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The following chapters are based on a series of 
Lectures delivered before the Society of Accountants 
in Edinburgh, the Institute of Accountants and 
Actuaries in Glasgow, and the Institute of Bankers in 
Scotland. Some corrections have been made, and the 
matter has been broken up and arranged in sections 
for the convenience of the reader, but no substantial 
changes have been introduced, and the work bears 
throughout the impress of its origin. The success of 
the book on Money and Monetary ProUems (now in 
its 6th edition) has led the writer to hope that these 
additional chapters may also prove useful to the same 
class of readers. The treatment, as in the earlier work, 
is intended to be introductory and suggestive and such 
as may help to stimulate those engaged in practical 
business to a wider study of the principles and 
history of finance. 


University of Edinburgh, 
August 1902. 


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in 2007 with funding from 

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1. The money of the money market of the United Kingdom — 
§ 2. Its practical importance — § 3. General scope of argument — 
§ 4. Different kinds of material money — § 5. Representative 
money — § 6. On the use of economic methods — § 7. Necessary to 
separate the functions of money — § 8. Money as a general medium 
of exchange — § 9. Money as a standard measure of values— § 10. 
Money as a standard for deferred payments — § 11. On the meaning 
of stability of value in the standard — § 12. Money as a store of 
values — § 13. Resume of the argument — § 14. The definition and 
meaning of " money " must vary with its monetary function — § 15, 
The standard as determined by positive law — § 1 6. The medium 
of exchange line as determined bylaw — § 17. Gold itself strictly 
not money but money material — § 18. In monetary problems 
necessary to state what meaning of money is intended Page 1 



1. Introductory — § 2. International debts — Exports and imports — 
§ 3. Real par of exchange — § 4. Trade of countries and of individual 
traders — § 5. Other elements in international indebtedness com- 
pared with exports and imports— § 6. Exports and imports typical 
of all international debts — § 7. Traders in each country receive 
payment in money of that country — § 8. Meaning and object of 
foreign exchanges — § 9. The mint par of exchange— § 10, Limits 
of fluctuations — Gold points — § 11. R6sum^ and illustrations — 
§ 12. Favourable and unfavourable exchanges— § 13. Historical 
and present importance of— § 14. Short and long exchange— 
§ 15. Influence of rate of interest— § 16. Of state of credit — 
§ 17. Variable effects of depreciation of currency — § 18. First 
case— § 19. Second case— § 20. Third case— § 21. The silver 
exchanges — § 22. Summary of results .... 22 




§ 1, Interest on money and on capital distinguished — § 2. Illustrations 
— § 3. Difficulties in definition of capital — § 4. Interest on capital 
divided into PROFiT-interest and LOAN-interest — § 5. LoAN-interest 
— § 6. Interaction between the two rates— § 7. Interest is a price 
and subject to the laws of prices — Competition and monopoly — 
§ 8. Widening of markets with progress — § 9. The supply of loan- 
able capital — Production — § 10. Effective desire of accumulation — 
§ 11. Security— § 12. Demand for capital, and first for unproductive 
purposes—! 13. Demand for productive purposes — § 14. Forecast 
— § 15. Effects of war — § 16. Interest on loanable money — § 17. 
Importance of legal tender— § 18. Supply of legal tender inelastic 
— § 19. The bank rate and the market rate — § 20. Interaction of 
interest on capital, and interest on money as such — § 21 . Pro- 
bable effects of great gold discoveries— § 22. Practical illustra- 
tion Page 42 



§ 1. Monetary and commercial crises distinguished — § 2. In monetary 
transactions ultimate solvency not sufficient — § 3. DefeiTed con- 
vertibility and suspended convertibility— § 4. Possible over-issue 
of bank notes — § 5. Same principle applicable to other forms of 
credit — § 6. Banks of deposit and banks of issue — § 7. Deposit 
banks subject to little legal control — § 8. Causes of financial crises 
— Insufficient reserve — § 9. The credit superstructure — § 10. Causes 
of commercial crises — Over-speculation — Historical Cases — § 11. 
Similarity in development — § 12. The tulip mania— -§ 13. Other 
speculative manias—^ 14. Other causes — Excess of fixed capital 
— § 15. Over-production — § 16. Raw materials and the seasons 
— § 17. The sun-spot theory— § 18. Theory of credit cycles— § 19. 
Importance of reference to history 63 




WHAT IS "money"? 

§ 1. Tlie money of the money market of the 
United Kingdom. — In a very able address on the 
Constitution and Course of the Money Market, 
delivered in 1888 by Dr Charles Gairdner, late 
manager of the Union Bank of Scotland, the intro- 
ductory sentences are as follows : " The money market 
of the United Kingdom is an institution of great 
importance and of some complexity. It has gradually 
grown to enormous proportions, and embraces a find 
almost equal in amount to the sum of the National 
Debt. This fund is held by the banks, is practically 
at call, and is repayable in gold; and yet ninety-five 
per cent, of it is engaged in promoting the industries 
and material interests of the country and the world, 
while only five per cent, is actually held in coin." If 
you consider carefully the meaning of this statement. 


it must strike you that, in spite of your familiarity 
with the state of things described, it is a very ex- 
traordinary statement. The fund of money of the 
money market is, on this calculation, over £600,000,000 
in amount ; 95 per cent, of it is apparently not in the 
market at all, that is to say, not in the banks by which 
it is said to be held ; and only 5 per cent, is actually 
in coin. It may be added also that the total amount 
of coin in the United Kingdom is only about one- 
sixth of the total money of the money market as given 
by Dr Gairdner, and it is not in any sense under the 
control of the banks, but is being circulated from 
hand to hand. 

§ 2. Its practical importance. — Since, then, the 
greater part of the " money " of the money market is 
not metallic money, the question is, " What is it ? " 
It is no doubt something very real, for, as we all know, 
the abundance or scarcity of " money " affects the rates 
charged by banks for advances and discounts, and in 
that way afifects the whole trade of the country. When 
the scarcity of money becomes extreme, we have indeed 
a commercial crisis, and for the time being all the trade 
of the country is thoroughly disorganised. And we 
know also by experience that at times of crisis the 
amount of metallic money or money material held by the 
banks is of the most vital importance. In the words 
of Walter Bagehot, the author of Lombard Street, 
and a banker and an economist of the first rank, " All 
our credit system depends on the Bank of England for 
its security. On the wisdom of the directors of that 
one joint-stock company it depends whether England 
shall be solvent or insolvent." And if the precise 


method of stating the truth seems rather overstrained, 
there is no question of the central fact. Once the 
real gold reserves available for banking purposes get 
below a certain level — which again is variable accord- 
ing to circumstances — the whole monetary system of 
the country becomes clogged, and for the time almost 

§ 3. General scope of argument. — The subject I 
propose to discuss in this and the following chapters is 
in reaHty "The Constitution and Functions of the 
Money Market." In the first chapter I shall examine 
the meaning and nature of the term " money " ; in the 
second I shall examine under the title of the " Foreign 
Exchanges " the interaction of the " money " of differ- 
ent countries ; in the third I shall treat of the rates 
charged for loans of '•' money " under the title of the 
" Rate of Interest " ; and in the fourth I shall give 
some account of the disorganisation of the money 
market under the title of " Commercial Crises." On 
each of these topics it would be much more easy to 
write a treatise than a chapter, and in each of them 
also the familiarity of the terms employed conceals 
great difficulties. Accordingly, at the risk of appearing 
too simple, I shall give most attention to the funda- 
mental principles ; but at the same time, in order not 
to appear too theoretical, I shall endeavour to illus- 
trate the principles by reference to concrete facts of 
striking importance in themselves. 

§ 4. Different hinds of material money. — In dealing 
with the question What is " money " ? we may begin 
by a rapid survey of the various " things " that have 
been in the past or are in the present actually called 


" money." You will find in the book on Money, by 
the late Professor Jevons, an interesting account of a 
great variety of primitive kinds of money — e.g., cattle, 
slaves, tobacco, dried fish, straw mats, skins, and many 
others. You will also find in the very remarkable and 
learned work of Professor Eidgeway on the Oi^igin of 
Currency and JVeight Standards excellent illustrations 
of the beginnings of the evolution of "money." In 
the course of progress the metals gradually displaced 
other substances ; in the struggle for monetary exist- 
ence amongst the metals, silver and gold were the 
survivors ; next, in the duel between gold and silver, 
for centuries silver held the supremacy ; and it is only 
in the last quarter of a century that gold has obtained 
the position of being practically the world standard for 
material money. 

§ 5. Representative money. — Long, however, before 
the battle of the standards had become critical, some 
of the most important " money " functions had come 
to be performed by other " things," these other 
"things" being embraced by Jevons under the 
comprehensive term "representative" money. The 
substance of all these things, if it can be called 
substance, is in effect credit; and although for 
certain purposes bank notes seem to have more 
of the nature of metallic money than do bills 
of exchange or cheques, as a matter of fact, in the 
money economy of the present day, bills of exchange, 
and especially cheques, are of far greater importance 
than bank notes. You might without much incon- 
venience abolish bank notes and carry on all internal 
trade and all foreign trade by coin, cheques, and bills 


of exchange, but without cheques and bills or some- 
thing of the same kind our present monetary system 
would be impossible. These various instruments — 
these credit documents — perform most important 
monetary functions ; of this fact there can be no 
doubt. The latest return of the London Bankers' 
Clearing-House gives nearly 10,000 millions sterling 
as the amount of the cheques, bills, etc. for the year 

I have said that bank notes are now of relatively 
small importance, but it was not always so. The 
history of Scottish banking in particular shows of 
what vital importance were the one-pound notes, and 
by no one has this importance been better brought 
out than by Sir Walter Scott in his famous letters 
on the Currency to the editor of the Edinburgh 
Weekly Journal, under the pseudonym of Malachi 
Malagrowther. The publication of these letters, it 
may be said, preserved for Scotland its one-pound 
note. The one-pound note, — this is the sum of Sir 
Walter's argument, — "converted Scotland from a 
poor, miserable, and barren country into one where, 
if nature has done less, art and industry have done 
more, than in any country in Europe, England herself 
not excepted." 

§ 6. On the use of economic methods, — And here, 
if you will allow me, I will interject a general remark 
on the study of economics. It is necessary in the 
first place to get a real grip of economic methods, 
and especially of the method of abstract analysis. If 
you start at once with what you are pleased to call 
facts, you will make no progress whatever ; you might 


as well hope to understand botany by taking at 
random a barrow-full of weeds and making your own 
classifications and dissections without reference to the 
science of the subject. You must in economic science 
in general, and in monetary science in particular, get 
firm hold of leading principles, or, if you prefer, of 
guiding hypotheses ; you must not be afraid of abstract 
reasoning. Thorold Eogers, who collected an invalu- 
able mass of materials in his great work on the 
history of Six Centuries of English Prices, fell into 
the most serious errors in his commentaries and deduc- 
tions, simply because he despised and failed to under- 
stand the abstract theory of money and prices.'^ The 
corresponding work for France, also for six centuries, 
by Vicomte d'Avenel, is in this respect far superior to 
that of Eogers, because the author has taken the 
trouble to make himself a master of theory. You 
must, then, begin with theory — abstract, hypothetical 

But it is equally important to observe that you 
must end with facts and with history; your theory 
is only preliminary. And in dealing with historical 
facts, you must not expect to find them all nicely cut 
and dried and ready to be ticketed with some par- 
ticular form of some particular theory. Real facts 
are never isolated in this way ; they are intermingled 
with all kinds of other facts, and that is why you 
require your analytic methods to make the separation. 
And, moreover, facts of one kind being so intertwined 
with facts of other kinds, you must be prepared to 

* There is similar weakness in his most interesting work on the 
First Nine Years of the Bcmk of England, 


search in very unlikely places. Most of you will not 
look naturally to Sir Walter Scott for the history of 
Scottish banking, but on the important phase to which 
I referred he may rank as an authority; and I may 
say incidentally that there is more economic history, 
that is to say history dealing with the real life of the 
people, in the novels of Sir Walter Scott than in any 
general history with which I am acquainted. I 
apologise for the length of this digression, and turn 
again to my abstract theories. 

§ 7. Necessary to separate the functions of money. — 
Seeing, then, that in actual usage the term money is 
so variable, it is hopeless to begin with the so-called 
facts ; we must take our monetary system to pieces to 
discover the working ; in other words, we must consider 
separately the various functions of money. We shall 
then find that the reason why it is so difficult, if not 
impossible, to frame a definition of " money " which 
shall include all the " things " actually called " money," 
— the reason is that some of the functions of money 
are best performed by some things and others by other 
things. This is true even of the so-called primary 
functions, and only when we have examined these 
primary functions shall we be able to determine if a 
simple definition of money is possible. 

§ 8. Money as a general medium of exchange. — The 
first great function of money is to provide a general 
medium of exchange. It is usual to begin an account 
of this function by reference to the inconveniences 
of barter, as in the example of the prima donna on a 
voyage round the world, who, in exchange for her songs 
in the Society Islands, was to get a third of the receipts. 


When counted, her share consisted of three pigs, twenty- 
three turkeys, forty-four chickens, four thousand cocoa- 
nuts, and large quantities of bananas, lemons, and 
oranges. The only method of saving this wealth was 
to set the live stock to devour the fruit, and although 
this may be called a primitive form of banking, it is 
highly inconvenient. 

After some such preliminary statement of the incon- 
veniences of barter, and the insinuation that barter is 
only proper for savages, it is usual again to drag up 
barter from these lowest deeps and to set it on the 
highest pinnacle of civilisation. We are told that all 
exchange is in reality barter, that commodities pay for 
commodities, and that money is only an intermediary. 
That trade is incapable of development when confined 
to direct barter, and also that all trade is in the last 
resort barter, are both truths of the highest importance. 
And both propositions being true, the appearance of con- 
tradiction must be an appearance only. All the difficulty 
would be avoided if it were stated that all exchange is 
ultimately barter, but that " money " is in general a 
necessary intermediary. To describe money as " only " 
an intermediary is to suggest, at anyrate, that it might 
be dispensed with. And if by " money " we mean 
exclusively metallic money, that is perfectly true ; but 
if we mean that the monetary function, as performed 
by some representative of this metallic money, can be 
eliminated and dispensed with, that is perfectly false. 

You can only realise the fundamental importance of 
this primary monetary function by tracing the stages of 
industrial progress. The gradual substitution of ex- 
change by money for exchange by barter has been one of 


the greatest agencies in civilisation. Without money in 
its simplest form, that is in the shape of cattle or skins 
or some material thing generally desired and acceptable, 
trade would have been strangled in its infancy. And 
without money in its most highly developed form, that 
is in the form which it assumes in banking, modern 
industry would be impossible. In any just analysis 
banks are as necessary to production as are ships, 
railways, or factories. 

But before leaving this primary function of money, 
that is, as a medium of exchange, we may go one step 
further. It is not necessary in modern commerce that 
some credit document, such as would be taken by a 
banker, should directly represent so much coin at every 
transaction. Besides cheques and bills, there are book 
credits, and even book credits are not necessary. It 
is sufficient that the commodities to be exchanged shall 
be expressed in terms of money, and in this case a 
relatively small balance (if any) of money need be 
transferred. In the case of international trade, indeed, 
we often have cases in which commodities are directly 
exchanged for commodities without the intervention of 
any form of credit. In this and similar cases, however, 
the monetary function passes into that of a measure of 
values. Both sets of commodities are measured in terms 
of money, and this is very different from simple barter. 

§ 9. Money as a standard measure of values. — It 
is time to observe then, secondly, that money is 
required not only to furnish a common medium of 
exchange, but to provide a standard measure of values, 
or common measure in which all values can be 



The necessity for a common measure of values 
appears very early in history. Thus, in the early 
medieval period, when rents were actually paid in the 
shape of so much labour or so much produce, it 
became customary to measure the values in terms 
of money. And in our own times valuations are made 
for all kinds of purposes as well as for actual ex- 
changes. Thus, historically and actually, we may 
separate the function of money as a measure of values 
from the function as a medium of exchange. But the 
two are so closely connected, that though there may 
be measurement without exchange, there cannot be 
exchange without measurement, that is, in the ordinary 
course of modern trade. 

In spite of this close connection, however, it is 
important to observe that the actual medium may not 
itself be the standard measure ; it is enough if it is 
related to the standard as multiples or sub-multiples, 
or in any exactly determinate way. At present, in 
the United Kingdom, the sovereign is the standard 
unit of value ; all values are measured in numbers, or 
in parts of sovereigns or pounds sterling. But the 
actual payments may be made by bronze, silver, notes, 
cheques, or entries in books. And the unit of value 
which itself constitutes or determines the standard 
measure need not itself be a coin at all. Thus, in 
most European countries the standard unit of value 
was originally the pound of silver, but there was never 
a coin of that magnitude or ponderosity. In fact, for 
centuries in England, though the standard measure 
was the pound of sterhng, the only coins of any 
importance were silver pennies — the table, twenty 


pennyweights one ounce, and twelve ounces one pound, 
shows the original relation of the penny coin to the 
pound measure: the pennyweight was literally a 
penny weight. 

If all transactions and exchanges were effected 
immediately, anything that is universally accepted 
would serve as a standard measure of values. Thus, 
for example, inconvertible bank notes, at any 
particular moment, will effect exchanges just as well 
as convertible notes or coins. If others accept the 
notes at the same valuation in any market, that is 
sufficient. But as soon as we consider the production 
of things, we pass from a moment of time to a more or 
less prolonged period of time. 

§ 10. Money as a standard for deferred payments. — 
It is this element of time which gives rise to a third 
primary function of money, namely, to provide a 
standard for deferred payments. Both theoretically 
and practically this function of money presents the 
greatest difficulties. The real meaning of any 
monetary contract is liable to be disturbed by fluctua- 
tions in the value of the monetary standard. Here, 
again, the best and most easy example is in- 
convertible paper. Suppose the notes were constantly 
changing in value, and that in the course of a week 
or a year you had to pay for every new purchase twice 
as much in notes, whilst for your old contracts, 
including your income, you only receive the old amount 
of notes, obviously you would be deprived of half the 
purchasing power of your money. That is the 
essential evil of inconvertible paper ; it fluctuates in 
value, and vitiates the real meaning of contracts. In 


extreme cases it ceases to fulfil this function of money 
altogether, and monetary bargains are made on some 
other basis in spite of legal prohibitions and penalties. 
Now what is true of inconvertible paper in a 
magnified form is true of every standard for deferred 
payments in a greater or lesser degree. You make 
a contract on a gold basis — you will no doubt receive 
so much gold, or what represents so much gold, when 
the contract matures ; but what the value of that 
gold will be depends entirely on the course of prices 
in the meantime. And, as a rule, if you take any 
selection of representative commodities, there is some 
movement in prices ; that is to say, so much gold 
purchases more or less of various things and services. 

§ 11. On the meaning of stability of value in the 
standard. — So long as the conditions of production 
and of demand are liable to change, it is impossible to 
get any standard with absolute stability of value, and 
the utmost we can aim at is relative stability of 
value. To attain this end we may eliminate certain 
common causes of fluctuation. Thus, for example, as 
regards supply, it is quite clear that if you have a very 
large durable stock, the variation in the annual pro- 
duction will be of minor importance. The annual 
supply of gold, for example, is always small relatively 
in the total world's supply, unlike the annual supply 
of wheat. Thus, so far, gold is a better standard 
than wheat. Again, for some things there is a 
fluctuating demand, and for others relatively a steady 
demand ; and here again gold has the advantage 
compared with other substances that at different times 
have been used as money. 


At first sight it seems as if the want of stability of 
value in the standard itself is a very terrible thing ; 
but in this world there is perhaps nothing practical 
which attains the perfection of theory, and fortunately 
within limits this want of perfection is under ordinary 
conditions of no practical importance. Your yard 
measure expands and contracts with every change in 
temperature, but for ordinary purposes this is of no 
importance. In the accurate measurement of time, 
however, such contraction and expansion must be 
allowed for, and you have great skill displayed in 
making compensations in chronometers ; and similarly 
in certain astronomical observations and calculations 
an error in the instrument of the smallest degree may 
vitiate the result, and incidentally send a big ship to 
the bottom of ocean. Fortunately, as regards value, no 
such precise measurements are required for practical 
purposes — everything is, as a rule, done within 
reasonable margins. It is only occasionally, with very 
great change in the conditions of demand or supply, 
that serious changes occur in the value of the money 
material that constitutes the standard. On such 
occasions there may be a very real disturbance of the 
meaning of monetary contracts and a very real dis- 
turbance of the distribution of wealth. Even in this 
case, however, the evil ought not to be exaggerated. 
The loss of one is the gain of another in any monetary 
disturbance, and the evil only becomes serious where 
the uncertainty actually dominates the volume of 
trade and production. 

§ 12. Money as a store of values. — To the three 
primary functions of money already considered we may 


add a derivative function. Money may be used as a 
store of values. In its elementary form this function 
is extremely simple — it consists simply of hoarding so 
much actual metal. But in the course of development 
this function of money has also become much more 
difficult of comprehension. To pay money into a bank 
by means of a cheque is very different from putting — 
according to the French idiom — little soiis into a big 
stocking. In the case of the cheque, the only material 
difference consists, as a rule, in the change of a few 
figures in the books of one or two banks. And yet we 
speak as if the money were " stored " in the bank. 

§ 13. E4sum4 of the argument. — Thus, again, we 
are led back to the original question propounded as 
the problem of this lecture, namely. What is " money " ? 
What is this " money " that I put in the bank when I 
pay in a cheque, and What does the bank do with the 
"money"? We may indeed ask not only What is 
the " money," but Where is the " money " ? 

The answer to the question " What is money ? " 
which serves to cover most of the popular usages, is 
the answer given in the late Professor Walker's book 
on Money — " Money is that money does " — or, in other 
words, anything which performs the functions of money 
may be classed as money. 

But then all the difficulties of the definition reappear 
when we ask the further question : In order that a 
thing may be classed as money, must it perform all the 
functions or only one or two of these functions ? Take, 
for example, concret^j cases : In this country, for 
practical purposes, the gold coinage only fulfils all the 
functions. Gold only is compulsory legal tender under 


all conditions for the fulfilment of monetary contracts ; 
Bank of England notes, for example, are not legal 
tender by the bank itself, and other bank notes are 
still more restricted as regards this function ; even the 
other coins made of silver and bronze, though 
popularly classed as money, have only a limited 
acceptance — they are, indeed, " token " money, and 
legally on the same footing as bank notes except for 
small payments. 

The sovereign, again, is, in this country, the only 
standard measure of values ; it is so, however, simply 
because the law has so determined. When a country 
is obliged to resort to inconvertible paper, it very 
often prohibits the use of gold as a standard, and by 
penalties tries to make its notes the standard. If we 
refer back to history we find examples of what is 
called the double standard, or better the alternative 
standard of gold or silver — that is to say, at the 
option of the debtor a monetary contract might be 
met by so much gold or so much silver, the rate 
being in general determined by law. On various 
grounds economists have proposed other standards, as, 
for example, an amalgam of gold and silver, or notes 
representing so much gold and silver. 

Again, in this country gold is the standard for 
deferred payments. Take the National Debt : it is 
repayable in gold, though it may not be repaid for 
centuries. Similarly as regards many perpetual 
debentures, the interest is payable in pounds sterling — 
that is to say, gold. But when we take very long 
periods, changes in the value of the standard may be 
of practical importance. In this case we have all 


the difficulties connected with appreciation and de- 
preciation, some of which will be considered in 
connection with the ** Foreign Exchanges." To remedy 
these difficulties some economists have proposed a 
tabular standard. In effect, this is a composite 
standard composed of a number of representative 
commodities. It is assumed that the debtor will 
covenant to pay not so much gold, but so much 
purchasing power, and thus the amount of gold money 
to be paid would vary with the course of prices. 

Finally, when we consider the function of money 
as a store of value, the most important store is, in 
this country, the reserve of gold in the Bank of 
England. Most of the rest of the money that is 
deposited or stored in our banks is only "represen- 
tative " money ; it is only supposed to be repayable in 
gold. As a matter of fact, if all the so-called money 
which is supposed to be repayable at call were 
demanded at the same time, only a very small 
percentage could be paid. But although all this 
" bank " money could not be changed into gold at 
any particular time, and although it only represents 
gold in the highly conventional sense that it is re- 
payable in gold, if demanded, it is not to be con- 
sidered as in any sense' unreal or intangible. The 
funds of the banks which are not represented by gold 
are represented by other forms of property, as, for 
example, by the produce and manufactures against 
which bills are drawn and are taken to the banks for 
discount, and also by the Government and other 
securities which are really mortgages over the property 
of the nation or of companies or of individuals. 


It was said by Sir James Steuart, a great writer 
who preceded Adam Smith, that any form of property 
could be melted down into bank money. But the 
aggregate amount of this *' bank " money must 
always depend partly on the amount of the real 
reserve available, and partly on the nature of the 
demands likely to be made on this reserve. The 
progress of banking in one important respect is shown 
by the diminution in the proportion of gold reserve 
to liabilities which it is necessary to keep, and this 
again depends partly on the demands for gold for cir- 
culating purposes — including transmission abroad — and 
partly on the credit of the banking system as a whole. 

§ 14. The definition and meaning of " money " must 
vary with its monetary function, — It would obviously 
be absurd to say that only the gold of the money 
market is money, and still more absurd to go to the 
other extreme and say that the other forms of property 
pledged directly or indirectly to the banks are money. 
If, then, for the last time we put the question : 
What is " money " ? — As the result of our inquiry 
into the monetary functions, the only satisfactory 
answer appears to be that we must recognise that 
there are various kinds of money, and that the 
definition must vary according to the monetary 
function that we are considering. In reality, instead 
of trying merely to frame a verbal definition, we ought 
always to make clear the different monetary functions. 
And a good practical rule is, as in other similar cases 
in economics, to use qualifying adjectives indicating 
the Jcind of money or the kind of monetary function 
to be considered. 


§ 15. The statidard as determined hy 'positive 
law. — The standard of value in any country is exactly 
determined by the law of that country, and this 
definition governs the interpretation of all monetary 
contracts. How far the use of such a standard is 
compulsory is also a matter of law, and how far the 
law can be carried out depends partly on public 
opinion. As a matter of fact, at the present time 
most commercial contracts in this country are expressed 
in terms of " money," that is to say, in terms of the 
pound sterling ; but if people so desire, there is nothing 
to prevent them making bargains to make payment 
according to a tabular standard or any other standard. 
But, as a matter of history, in the course of time the 
governments of all countries beyond a certain stage 
have adopted as their standard some definite amount 
of gold or silver (and in some cases an alternative at 
a certain rate). At the beginning of last century 
England formally adopted the gold standard, and in 
the last thirty years the gold standard has been adopted 
to such an extent that it may now claim to be the 
commercial standard of the world. The gold moneys 
of the different countries are in this way related accord- 
ing to the amount of fine gold they contain. In 
certain countries, however, silver is still the standard, 
and in others there are various legal standards which 
are only indirectly or partially on a gold basis, as, for 
example, the rupee in India. These other standards, 
however, for the purposes of international trade, may 
be reduced to terms of gold at any particular time.'^ 
§ 16. The medium of exchange line as determined 
* Compare the chapter on " The Foreign Exchanges." 


ly law. — The medium of exchange in any country 
which people m.ust accept in satisfaction of a debt 
when offered by the debtor is also a matter of law, 
and how far its compulsion can be extended to future 
contracts is a matter of Government and public opinion. 
How far, as a matter of fact, people may and do accept 
other means of settlement in place of legal tenders is 
a matter of habit and convenience, and how far such 
acceptance is final or irrevocable is a matter of law. 
These various " things," which locally and temporarily 
so far fulfil the function of money as a medium of 
exchange, may be said to represent, or to be based 
upon, standard money — that is, in most countries, 
gold, directly or indirectly. Thus, gold in gold- 
standard countries may also be said to be the funda- 
mental medium of exchange, though in some cases the 
foundation may be in bulk and value relatively 
small compared with the superstructure. The actual 
use of gold may be economised to a marvellous extent 
by the use of " representative " money ; but it cannot 
be dispensed with altogether, any more than the founda- 
tion of a building. 

§ 17. Gold itself strictly not money hut money 
material. — Gold, then, under present conditions 
certainly fulfils all the monetary functions to a degree 
that is not true of anything else. But, to raise one 
last difficulty for purposes of illustration, gold itself is 
not money but only money material^ and therefore so 
far only representative of " money." At the time of 
the great Australian gold discoveries in the early 
'Fifties, gold in South Australia is said to have fallen 
to 45s. an ounce, and in Victoria to 60s., as compared 


with the mint price of £3, 17s. 10|-d. Of course 
with open mints and no charge for coinage such a 
difference could not arise, although even in London 
at the present time there are on occasions slight 
differences between the mint price and the market 
price of gold. But this last difficulty is not raised 
for purposes of explanation but of illustration. The 
point is, that for certain purposes the money material 
— even gold itself — must be distinguished from money. 
In conclusion, then, we can only reaffirm the 
position already laid down : For various purposes 
the term " money " is used in various senses, which 
are best indicated by qualifying adjectives. Thus we 
may speak of metallic money, both " standard " and 
" token" ; of 'paper money, including convertible and 
inconvertible bank notes ; of " representative " money, 
including not only bank notes but various forms of 
bankers' credits ; we may speak of " national " money 
and of " international " money ; of money in active 
circulation, or of money in passive reserve ; of money 
as legal tender and of money as the currency in 
practical use ; we may speak of the value of money, 
meaning thereby the rate of interest^ or of the value 
of money, meaning thereby its exchange value, as 
determined by the level of prices; and thus, finally, 
we are led to consider the appreciation and the 
depreciation of money, and the relative values of different 
forms of money and money materials. 

§ 18. In monetary problems necessary to state what 
meaning of money is intended. — Accordingly, when we 
are dealing with monetary problems, it is generally 
necessary to lay down at the outset the meaning to be 


attached to the term " money " in the course of the 
argument — a precaution of special importance in 
dealing with the " quantity theory of money" Other- 
wise, if we do not take this precaution, it is hardly 
possible to escape confusion. And this habit of 
constantly looking into the meaning of money has its 
practical advantages. The whole business of banking 
consists in estimating the demand for money of 
different kinds for different purposes : in some cases a 
demand for money may mean no more than a change 
of figures in bankers' books ; but in other cases it may 
mean that the Bank of England is obliged to borrow, 
as on certain historical occasions, actual gold from the 
Bank of France. 

\_Note. — For a full development and illustration of 
the argument, see the writer's Principles of Political 
Economy, vol. ii. chaps, xi.-xviii.] 



§ 1. Introductory. — In attempting to give in a 
single chapter an account of the theory of the foreign 
exchanges, it is obvious that the attention must be 
mainly devoted to general principles. Those who 
require practical details may be referred to Tate's 
Cambist, or to the A B C of the Foreign Exchanges 
by Mr George Clare. That the general theory 
requires careful statement, and is not so obvious as is 
sometimes assumed, is evident from Viscount Goschen's 
standard work, which is still of the highest value on 
account of its principles, although most of the 
examples are altogether out of date. 

I shall first of all explain the meaning of the terms 
and the extent and limits of the fluctuations, and then 
I shall notice, so far as space permits, some of the 
important indirect effects on banking and trade of 
certain kinds of fluctuations in the exchanges. 

§ 2. International debts — Exports and imports. — 
The term foreign exchanges refers to the settlement of 
international debts. Accordingly, in the logical treat- 


ment of the subject, we ought to begin with the 
analysis of international indebtedness. The first 
element to be considered is the amount of the exports 
and imports. It is a commonplace of economic 
theory that imports are paid for by exports. And if 
there were no other elements in international indebted- 
ness, imports could be paid for in no other way. 
Either the value of the exports must equal that of the 
imports, or else the trade must cease. A country that 
does not itself produce gold could not go on paying for 
imports with money; it must replenish its money 
supplies, and it could only do so by selling exports 
abroad. Suppose that a country had an excess of 
imports which it could only pay for by sending money 
or money material. As the country was denuded of 
its money, prices would fall ; it would become a good 
country to buy from and a bad country to sell to ; and 
thus exports would be stimulated and imports would 
be checked until the adverse balance was reversed. 
In practice, in modern societies, long before the 
country was denuded of its money there would be, 
through the drain on the reserves of the banks, such a 
check to credit that prices must fall. But the 
principle is still the same : Provided exports and im- 
ports are the only elements in international indebted- 
ness, prices must be so adjusted that exports and im- 
ports balance, or else the trade must diminish or cease. 
§ 3. Real par of exchange. — The operation of this 
principle is hidden by various conflicting circumstances. 
As Adam Smith pointed out long ago, it is practically 
impossible at any time to say what is the balance of 
trade between any two countries. What is some- 


times called the " real " par of exchange, in the sense 
of an equality of indebtedness, is much better called 
an "ideal" or hypothetical par — a useful assumption 
in certain kinds of reasoning. It is altogether different 
from the " mint " par, or " nominal " par, which expresses 
a definite concrete fact, as is explained later on. 

§ 4. Trade of countries and of individual traders. — 
Again, for simplicity of reasoning, we say that one 
country — England — trades with another country — 
France, just as if the two countries were run by a 
gigantic trust on each side, and as if the state of 
account were reckoned up and published every day. 
Nothing, of course, could be further from the truth. 
It was well said by Eicardo, who spent most of his 
days in making money on the stock exchange and his 
nights in making fame in economic theory, that every 
transaction in commerce is an independent transaction. 
The trade between France and England is not run by 
two trusts, but by a multitude of independent 

The reconciliation between the two positions is 
found in the course of prices. The merchants have 
to make their bargains in terms of prices, and 
prices are influenced not only by particular relative 
causes but by general causes. And amongst such 
general causes are the terms on which bills can be 
discounted or advances from banks obtained. And, as 
will be shown presently, the rate of discount depends, 
inter alia, on the course of the foreign exchanges, 
which again depends, inter alia, on the balance of 
exports and imports, or rather on the payments that 
have to be made on account of trade transactions. 


§ 5. Other elements in international indebtedness 
compared with exports and imports. — There are, how- 
ever, other elements in international indebtedness as 
well as exports and imports, on account of which pay- 
ments have to be made. These elements I shall only 
enumerate, as I must in some way economise my 
limited time. You will find them very clearly stated 
in Lord Goschen's second chapter; and in the page 
that forms the frontispiece to Mr Clare's little book 
you will see a debtor and creditor statement for London 
of international transactions. 

Besides exports and imports we have to take 
account of payments in connection with freights, the 
purchase or sale of stock-exchange securities, the 
advance of loans, the interest on loans, the expenses of 
governments abroad, the expenses of foreign residents, 
the obligations incurred by banks, the profits of com- 
missions of various kinds, and other minor elements. 
You will find it useful, I think, to translate all these 
various elements into the language of exports and im- 
ports; that is to say, to consider what would be the 
effect on the state of indebtedness if these various obliga- 
tions were equivalent to or expressed by a correspond- 
ing increase of exports or imports as the case might be. 
This, indeed, is not only a good practical rule, but is a 
necessary procedure when we seek to explain the course 
of international trade ; why, for example, year after 
year, the imports into the United Kingdom exceed the 
exports by many millions. This undoubted fact does 
not show that the imports are not paid for by the ex- 
ports, but only that some of the exports are not in the 
form of material commodities. Thus, for example, a 



freight has been well called an " invisible " export ; the 
advance of a loan — i.e., the capital sum — is, so to speak, 
an import of securities from the foreigner, and we must 
pay for the securities by exporting more commodities ; 
the interest on the loans, on the other hand, acts from 
this point of view like another invisible export — now 
we export, so to speak, the coupons and receive payment 
in the shape of so much additional imports ; the 
expenses of government or of absentees abroad may be 
regarded as if we actually were obliged to pay for ad- 
ditional imports to that extent — the imports being 
consumed on the way ; and finally, foreigners have to 
pay us, by sending us something of value — that is to 
say, really by adding to our imports — on account of 
our commissions in settling international transactions 
of various kinds. 

§ 6. Exjjorts and imports typical of all international 
dehts. — It appears, then, that not only are exports 
and imports the principal elements to be considered 
in international indebtedness, but that other elements 
may also be likened to them and expressed in terms 
of exports and imports, and, indeed, they have a 
precisely similar effect on the balance of indebtedness. 

We are justified, then, in dealing with international 
indebtedness, in taking exports and imports as typical 
or representative, and in that way simplifying the 
central problem. 

§ 7. Traders in each country receive payment in 
money of tJiat country. — If, however, it may be taken 
as axiomatic that the exports are paid for by imports, 
in the extended use of those terms, it is equally 
certain, as a matter of common observation, that the 


producers of these exports are paid for them in 
the money of their own country, and the producers of 
the corresponding imports are also paid for them in 
the money of their country. It is all very well to 
say that the coal exported by England is paid for by 
the wine imported from France, but it is pretty 
certain that the English colliers do not drink the 
French wine, and the French wine-growers do not 
burn the English coal. The English colliers even- 
tually receive English money, and the French wine- 
growers French money, for their respective productions. 
Accordingly, if we carry out the same reasoning as 
regards all the other exports and imports, we see 
that the settlement of this international indebtedness 
involves the conversion at some point or other of 
French money into English money, and conversely. 
The French consumers of English coal in some way 
or other have to pay for it in English money, and in 
some way or other to pay this money in England. 

§ 8. Meaning and object of foreign exchanges. — The 
way in which this is done is explained by the theory 
of the foreign exchanges. " The foreign exchanges," 
to quote the old standard work,"^ " are transfers from 
the money of one country to that of another effected 
by the operation of Bills of Exchange." 

It may, of course, happen that different " foreign " 
countries have identical currencies, but the terms of 
the definition do not exclude this case ; the essence is 
the transfer of money power from one country to 
another. The French consumer, through suitable 
agents or intermediaries, is obliged, not only to change 
* Tate's Cavibist, 


his francs into sovereigns, but the sovereigns must 
be paid in England. If, however, every independent 
transaction of commerce were settled independently, 
we should have a multitude of parcels of coin or 
bullion constantly flowing in about equal streams 
from and to every country. England would be 
receiving money for exports and sending away money 
for imports. But the resources of very early civilisa- 
tions were equal to avoiding this source of waste, 
and the foreign bill of exchange may be traced back, 
at any rate, to the middle ages. 

For simplicity, it is convenient to assume that in 
this method of the settlement of the indebtedness one 
country is altogether active and the other altogether 
passive — i.e., that one always draws and the other 
accepts. Suppose, for example, that American 
merchants export corn, cotton, etc. to England, and 
draw for the value on the corresponding English 
importers or purchasers. The bills being drawn on 
London entitle the drawers to receive money there 
from the acceptors. But so far they would be no 
better off, for they would have to fetch the correspond- 
ing gold from London. But suppose, further, that 
other American merchants buy from London piece 
goods of the same value as this exported corn. They 
can, of course, settle their debts by sending gold, but 
they can settle them equally well by buying these 
bills from the exporters and sending them to 
London, where they will be paid by the acceptors. 
By the intervention of these bills the remittance, 
to and fro, of bullion is avoided, and the American 
exporters of produce receive American money, and 


the English sellers of piece goods receive English 

§ 9. The mint par of exchange. — It is clear, how- 
ever, that the bills being payable in pounds sterling, 
and being sold for dollars, the first element in deter- 
mining the price of the bill is the relative value of the 
pound sterling and the dollar. This again depends 
on the amount of fine gold each contains, and what is 
called the mint par of exchange tells us how much of 
the other country's currency contains, according to its 
law, the same amount of pure metal as is contained in 
our standard coin, according to our law. The mint 
par is deduced from the legal definitions of the respec- 
tive standard coins. If we take the pound sterling as 
fixed, or as the basis, the mint par with U.S.A. is 4*866 
dollars, with France 25*2215 francs, with Germany 
20*43 marks. 

If the foreign coins were being exchanged at the 
same spot in order to be melted down, this mint par 
would also give the actual rates of exchange. But 
the term foreign exchanges refers primarily to a trans- 
action in which a bill (say) for pounds payable in 
London is sold for dollars received in America, and it 
is this difi'erence of place which accounts for the 
fluctuations in the rates of exchanges, or, as it is called, 
the rise and fall in the exchanges. 

I proceed, then, next to notice the principal causes 
of these fluctuations and the limits to their rise 
and fall. It is better now to pass from the simple 
case of one kind of export and one kind of import, 
and to include all the elements in international in- 
debtedness, and, i7iter alia, the invisible exports. 


and, if I may coin a similar phrase, the " intangible " 

§ 10. Limits of fluctuations — Gold points. — Suppose, 
then, at any particular time a number of people in 
New York have to make remittances to London, and 
that a number of other people in New York are anxious 
to sell various credit documents, bills, drafts, etc., which 
entitle the holders to receive money in London. If 
the demand exceeds the supply, the price of these bills 
(or other documents) will rise. But the limit of the 
rise will be given by the point at which it will be just 
as cheap for the American debtor to send actual gold 
to London. This is the out-going gold point from New 
York, and it may be taken as £1 = $4*8 9|- ; conversely, 
if the supply of bills exceeds the demand the price 
falls, and it may fall to such a point that it would be 
just as profitable for the owner of the bill — the Ameri- 
can creditor — to send for the gold. This is the 
incoming gold point to New York, and may be taken 
as £1 = $4-831 

§ IL Ii6sum4 and illustrations. — To resume: The 
mint par is just $4*8 6 6 = £1. If the rate rises to 
$4'89j, it generally pays to send us gold ; if it falls 
to $4*8 3 J, it generally pays to take gold from us.^ 
These gold points, or specie points as they used to be 
called, for export and import cannot, of course, be fixed 
with absolute precision, as they depend on the cost of 
transmitting the gold, but the average or normal is 

* If the dollar is taken as fixed and the ponce given as variable, the 
mintparis Jl = 49i'*«d., and the gold points are $l = 49d. lor us, and 
$l = 49|d. against us. If the dollar in New York would only buy 49d. 
in London, it would pay to send gold ; if it would buy 49§d., it would 
pay to fetch gold. 


approximately certain, and it is only under excep- 
tional conditions that these limits are exceeded. 

If you refer to Mr Clare's book,"^ you will see a 
diagram showing the course of the exchange at New 
York per cable transfer on London for the year 1891. 
In January, to begin with, the rate is low — $4*85|-, 
and it rises to the maximum (the out-going gold point 
from New York) in March — ^viz., $4'89j. It remains 
high till the end of June, when there is a fall to the 
minimum of $4*8 3| — the incoming gold point for New 
York. The general course of the fluctuations in this 
case is determined mainly by trade influences. The 
States, as a rule, ship to us large quantities of corn, 
cotton, etc. in the autumn, and from August to December 
the exchanges are therefore generally favourable to the 
States and, conversely, unfavourable to us. During 
the rest of the year the balance is in our favour and 
against America. In this particular year, however, it 
also happened that London was selling in America 
large quantities of American securities in the spring, so 
that there was an extra demand for remittances from 
New York to London. 

The difficulty of giving actual concrete cases for the 
purpose of illustrating the theory is that we cannot in 
this way take the theory in parts and in order of 
simplicity; the concrete cases generally require for 
their explanation the whole of the theory and some 
practical qualifications besides. And in this example, 
which I chose to illustrate the effect of exports and 
imports on the exchanges between New York and 
London, I have introduced two terms not yet explained 

* Note, p. 137. 


— namely, the term favourable, and the term cable 

§ 12. Favourable aiid unfavourable exchanges. — 
What, then, is the meaning of the expression that the 
exchanges are favourable or unfavourable, or for or 
against a country ? The use of the terms may be ex- 
plained in two ways — one partly historical, and the 
other very real at the present time. If we take our 
former illustration and consider the case of the Ameri- 
can importer, if the exchange is below par he is able 
to buy his remittance for so much less — he gives 
fewer dollars for a hundred pounds payable in London. 
Thus it looks as if American currency fetched more of 
English currency. In former times there was always 
much anxiety about the actual exchange of currencies, 
and this is one historical meaning of the term favour- 
able — i.e., to obtain more foreign currency than usual 
for the native money. There is, however, a deeper 
meaning — also historical. "When the exchange is 
favourable to a country it shows, so far — that is, 
omitting other elements of indebtedness — that the 
exports have exceeded the imports. Under the old 
ideas of the mercantile system this was considered a 
favourable state of trade. " Sell much and buy little " 
was considered the chief rule of the national trade 
economy. It is not necessary, again, on the one side 
to expose the fallacy, or on the other to indicate the 
element of truth, contained in this maxim. 

§ 13. Historical and present importance of — It is 
plain that, so far as any advantage was obtained from 
the state of the exchanges by way of trade, if the 
exchange was favourable to the importer or the buyer 


of the bill, it was so far unfavourable to the exporter or 
the drawer of the bill. Probably the idea was that 
the exporter would transfer any loss to his foreign 
debtor. This usage, however, of the terms " favour- 
able " and " unfavourable " — namely, as supposed to 
indicate the balance of trade — is now, or at any rate 
ought to be, only of historical interest. 

But, I hasten to say, there is a sense in which the 
terms, favourable and unfavourable exchanges, may 
still be used with a very real meaning. Gold is a 
commodity which, for many purposes, is very dififerent 
from any other commodity. The gold held by the 
Bank of England is of far greater importance to the 
United Kingdom than is indicated by its monetary 
value. If, owing to any cause, we exported suddenly 
twenty or thirty millions more of commodities than 
was usual at that period of the year — if, for example, 
owing to the outbreak of war between China and 
Japan we exported a mass of materials suitable for 
the mutual destruction of these friendly states, there 
might be some political protests and some interesting 
lawsuits, but, on the whole, the trade of this country 
would be stimulated, and possibly leap and bound. 
But if, on the other hand, these wily orientals were 
able suddenly and unexpectedly to withdraw from the 
Bank of England twenty or thirty millions of gold, 
which also is very useful in time of war, our trade, 
instead of leaping and bounding, might very possibly 
suffer from the depressing influence of a commercial 

It is the passage of gold from one country to another 
that gives the principal general interest to the foreign 


exchanges. To the great mass of the people of this 
country who are engaged in business of various kinds, 
the course of the foreign exchanges is in general of no 
interest whatever, except in one particular — namely, 
if there is a rise or fall, in consequence, in the rate of 
discount. That they see and feel. For one business 
man who considers the course of the foreign exchanges, 
a thousand consider the movements of the bank rate. 
There are also, it is true, other indirect influences 
which occasionally have far-reaching consequences and 
call for careful examination. In general, however, 
especially in this country, the principal interest of the 
foreign exchanges is in connection with the rate of 

§ 14. Short and long exchange. — And this leads me 
to notice the other term which arose in my New York 
illustration — namely, cable transfer. In itself this 
term requires no explanation, but it leads up to a 
point of importance — namely, the difference between 
the short exchange or exchange at sight, and the long 
exchange or after so many days' notice. This distinc- 
tion also, it will be found, is closely connected with 
the rate of discount. 

The typical instrument for settling international 
indebtedness is, as already pointed out, the bill of 
exchange, which arises from an actual trade transaction. 
If, then, this bill of exchange is not payable at sight, 
but, say for simplicity, after three months, its present 
value is subject to three months' discount. Accord- 
ingly, if in New York a cable transfer on London 
could be bought, say at par — i.e., if for one pound 
payable at once in London 4*866 dollars would be 


given, then for a pound payable after sixty days the 
discount must be subtracted. Thus, referring to the 
foreign rates of exchange in London quoted in the 
Economist at the date of writing, the New York 
cable transfer on London is £1 = $4-87|-, while the 
long exchange at sixty days is $4'84f . 

§ 15. Influence of rate of interest. — It may be worth 
while to consider this case with an example in which a 
remittance is sent/rom London (say) to Paris. If the 
London debtor can purchase for a pound a cheque for 
so many francs payable on demand, he will require for 
his pound so many more francs in a bill which must 
be discounted, and how many more francs will depend 
on the rate of discount in Paris. Thus, in the same 
number of the Economist, I find in the London course 
of exchange Paris cheques are quoted at 25'12J, which 
happens to be very nearly the gold point against us, 
and bills at three months are quoted at 2 5 '32 J. The 
principal cause of the difference is the rate of discount 
in Paris. 

In certain cases, moreover, the rate of interest, or 
rather the relative rate, in the country which draws 
the bills may be of importance in influencing the course 
of exchanges. Suppose, for example, that the rate of 
discount in Paris is much lower than in London, or 
suppose that the Bank of England raises its rate 
and that the conditions of the London money market 
are such that the market rate in London rises to the 
same extent, or it may be even more. What would be 
the effect on the exchange between Paris and London ? 
One natural and obvious result would be that Paris 
bankers would wish to send money for investment in 


London at the more profitable rate, and thus the 
exchange would turn — so far — in our favour. Tliis 
natural and obvious effect would be intensified by a 
less obvious cause. Bills drawn on London by Paris 
having their present value calculated at the London 
rate, would be a good investment for Paris bankers. 
Thus they would compete for these bills — not for 
remittance but for investment. This extra demand, 
however, must so far turn the exchanges in our 
favour still more, or at least make the movement more 
speedy. It is, of course, the difference in the rates in 
the two places which must be considered in this 

As I indicated before, as regards this country, the 
movement in the exchanges is generally only of 
interest in connection with the bank rate. If the 
exchanges turn against this country so that gold is 
exported, or even if a drain is anticipated, the bank 
rate is raised, and directly or indirectly this rise may 
operate on mercantile advances generally.'^ 

§ 16. Of state of credit. — The foreign exchanges may 
also be affected by the state of credit in both the 
countries considered. This is obvious from the fact that 
the documents used for remittance are credit docu- 
ments, and our typical bill of exchange depends ulti- 
mately on the credit both of the drawer and the accep- 
tor. The intervention of banks also has become of late 
years of more and more importance, and all banking 
rests on credit. The rate of exchange between any 
two centres, say London and Paris, will also be 
affected by the rates subsisting between these centres 

* Compare the chapter on •* The Rate of Interest." 


and other centres with which they have transactions. 
The principles applied, however, are the same, and 
indeed for purposes of theory we may regard the rest 
of the world as one great foreign country. 

Similarly the operations of banks in adding stability 
to the exchanges by creating paper for remittances to 
pay for imports, which are really paid for by exports 
at a later date, — those operations present no theoretical 

§ 17. Variable ejffects of depreciation of currency. — 
It seems to be otherwise, however, when we come to 
the case of the depreciation of currency and its effects 
on foreign trade. The problem is simple enough so 
far as the actual premium on gold is concerned. If a 
sovereign will buy so many francs at the rate of the 
mint par, and if the francs are depreciated, the 
sovereign must obtain so many more to the extent of 
the depreciation. If the depreciation is considerable, 
it may be said that the apparent course of the 
exchanges depends mainly on the extent of the 
depreciation. The other causes of fluctuation are still 
there, but they are altogether hidden by the premium 
on gold. There are also in this case no limits to the 
nominal or apparent rise in the exchange — that is, 
taking the sovereign as fixed and the depreciated 
currency as variable. 

So far the matter is simple enough. There is, 
however, a point involved which is by no means 
simple in theory, and is yet of very great practical 
importance. The question is this: Suppose the 
currency of a country, which was formerly on a gold 
basis, becomes depreciated owing to excessive issues 


of inconvertible notes, will this depreciation of itself 
tend to encourage exports or diminish exports (and, 
conversely, of imports), or will it have no real effect ? 
I believe that the correct answer to this problem is, 
that the effect will depend altogether on the way in 
which the depreciation takes place, and that the 
answer must be different in the different cases. 

§ 18. First case. — First, take the case in which the 
notes become discredited almost as soon as they are 
issued — that is to say, suppose that long before there 
are such abundant issues as to cause an inflation of 
prices through the increase in the quantity of currency 
a premium on gold arises. What will happen as 
regards exports and imports ? People exporting to 
the country in question, and selling for the inconvert- 
ible paper which is, we may suppose, practically the 
only currency, will only receive about the same price 
as before, but, owing to the premium on gold, they 
will not obtain the same amount of gold to take back 
or send back to their own country. 

Therefore, exports to the country with the depreci- 
ated notes will be checked. Conversely, exporters 
from that country will sell for the old prices reckoned 
in gold in other countries, and with this gold they can 
purchase more currency at home, and thus there will 
be a stimulus, so far, to exports from the country in 

§ 19. Second case. — But take now another case. 
It might happen that prices in the country considered 
rose more than was indicated by the premium on gold. 
The Government might make its issues with great 
prudence, and float a mass of this paper and gradually 


inflate prices before any danger of inconvertibility was 
suspected, and tbus without any premium on gold 
arising, and later, for a time at any rate, the inflation 
of prices might exceed the premium on gold. 

In this case exports to this country would be stimu- 
lated, and exports from it would be checked ; and the 
final result would be that the adverse balance must be met 
in gold ; then, as gold left the country the premium would 
rise, and ultimately it is quite possible that the effect of 
the depreciation might come to be exactly the opposite. 

§ 20. Third case. — Take now a third case. If all 
the parties concerned were practically to ignore the 
depreciation, and conduct all their exchanges on a gold 
basis, there would be no stimulating influence either 
way. But it is very doubtful if this theoretical result 
is ever attained in practice. The people who really 
pay for the imports are the consumers in the country 
with the depreciated paper, and the people who must 
eventually receive the money for the exports from this 
country are the producers there, and both consumers 
and producers in the country concerned are in general 
obliged to use this depreciated paper. 

The foreign trader may insure himself against risk 
by making his bargains on a sterling basis of exchange, 
but he cannot prevent the depreciation affecting the con- 
ditions of demand and supply in the internal markets 
of this country, and these markets are influenced by 
the extent and by the mode of the depreciation, and 
thus indirectly the foreigner also must be affected. 

§ 21. The silver exchanges. — The use of inconvertible 
paper is of very frequent occurrence, and has important 
indirect consequences. In recent years also the 


fluctuation in the rates of exchange between gold and 
silver have been of even greater interest and importance. 
The same principles must be applied, mutatis mutandis, 
as in the case of inconvertible paper. It would, 
however, be hopeless at the end of a lecture of this 
kind to tire your attention by trying to show the way 
in which the principles must be applied, or to discover 
to which of the three cases of depreciated paper the 
depreciation of silver may be likened. To those who 
wish to work at a good monetary problem I can 
heartily recommend the subject of the effect (if any) 
of the depreciation of silver on the prices of com- 
modities in gold-using countries. 

§ 22. Summary of results. — As the subject treated 
in this chapter is necessarily both technical and com- 
plex, it may be useful if, in conclusion, I restate briefly 
the principal positions. 

The term "foreign exchanges" refers to the 
settlement of international debts. These debts are 
expressed in the moneys of the respective countries. 
Accordingly, the first thing is to find out the relative 
values of these moneys according to the fine gold they 
contain. This gives the mint par. 

Next, we note that the comsumer in one country 
must in some way pay the producer in the other — that 
is, he must remit money or something that will command 
money — in the typical case, a bill of exchange. The 
price of these bills varies with the demand and supply, 
and the limits of the fluctuations are given by the 
cost of sending gold or of sending for gold. This 
gives the gold points or specie points. 

In most cases these fluctuations in the exchanges 


are ouly of interest to merchants directly engaged in 
foreign trade, and, being within narrow limits, are of 
little importance. But whenever the course of the 
exchanges is such that a drain of gold sets in, or is 
feared, there is a rise — and it may be a sharp and 
a great rise — in the bank rate. Such a movement 
may affect trade generally, and in extreme cases lead 
to a commercial crisis. 

Another case is also of general importance. If the 
currency of one country becomes depreciated, the 
premium on gold will rise to the extent of the 
depreciation, and there are practically no limits to 
this rise. The British dealer with the foreign country 
which has the depreciated currency may make himself 
safe by making his bargains on a sterling basis, but he 
cannot avoid the indirect effects of this depreciation. 
Under various conditions the depreciation of the 
currency of a country may stimulate or may diminish 
its exports. It really depends on the way in which 
the depreciation arises. 

A similar argument may be applied when one 
country has a silver standard and the other gold. 
The effect of the depreciation of silver upon the trade 
of silver-using countries depends on the causes and 
methods of the depreciation. The assertion that the 
depreciation of a currency acts as a bounty on exports 
may be true in some cases; in others, however, it 
would act like a tax on exports, and in any case these 
effects tend to disappear in time. 

The great evil of depreciation is that with every 
change in the degree of the depreciation a new set 
of disturbances may arise. 




§ 1. Interest on money and on capital dis- 
tinguished. — It was shown in the first chapter of 
this book that the term " money " is used with a 
variety of meanings. If, then, we take the term 
" interest " in what seems the most simple and obvious 
sense — namely, as the price paid for the use of a 
loan of money for a time — in order to get at the real 
or underlying meaning we must decide what is to 
be understood by "money "in this connection. We 
find on the first inspection that very often in those 
loans the " money " is merely an intermediary, and 
that what is really lent and borrowed — when the 
whole transaction is complete — is so much " capital." 
Take, for example, the common case of the conversion 
of some private manufacturing concern into a limited 
company. The company, in effect, borrows so much 
money from the investors and pays in return so much 
interest of various kinds and under various conditions. 
But this interest is only earned by converting the 

or THE 


^ OF 


money into various forms of productive " capital." 
The money in this case is only, to begin with, a medium 
of exchange, and the essence of the loan is " capital." 

In other cases, however, the primary object of the 
loan is not to obtain capital for extending production, 
but to obtain " money " in the sense of legal tender, 
or at least in some form that will be accepted as 
such — the object being to meet some prior monetary 
obligation. In times of financial crisis, for example, 
many houses may be perfectly solvent if only time 
is allowed for realisation, but they fail simply because 
they cannot meet in money their monetary obligations. 
Accordingly, most recent writers on the principles of 
economics have drawn a sharp distinction between 
interest on loanable '^ capital " and interest on loanable 
" money," although, unfortunately, writers on money 
articles constantly use the terms " money " and 
" capital " as interchangeable. 

§ 2. Ilhcstrations. — In an examination of causes 
and principles the distinction is fundamental, and it 
is so also as a rule in practical business. If we take 
the Bank of England rate as typical or representative 
of the rate charged for loanable money as such, and 
the rate on first-class securities or debentures as 
typical or representative of the interest on loanable 
capital, we find that there is often a considerable 
difference between the two rates. Whilst interest on 
capital is relatively very steady — the yield to 
consols not varying perhaps one per cent, in fifty 
years — the bank rate may sometimes be above and 
sometimes below, and the changes are often very 
frequent and occasionally violent, oscillating in the 


same period between 2 and 10 per cent. These 
dififerences are not to be explained by any difference 
in security or in risk. In both cases the security 
for all practical purposes may be considered perfect. 
I propose, then, to deal separately with these two 
kinds of interest, and to notice later on the interaction 
there may be between the two rates. 

§ 3. Difficulties in definition of capital. — I have 
used the expression interest on capital, but a very 
slight application of economic analysis shows that 
capital itself is even more difficult of definition than 
money. It would be hopeless, by way of introduction 
to a subject sufficiently complex already, to enter 
into all those difficulties, but by way of illustration 
I may mention the two most popular meanings. 
Some people — and they may quote the authority of 
Adam Smith — look on capital as wealth that yields 
a revenue ; others — and they may quote J. S. Mill — 
regard capital as wealth used in p^vduction. In some 
cases those dififerences of definition are of no practical 
importance, because the "capital" yields revenue 
by being used in production ; but in other cases there 
might be great dififerences between capital and non- 
capital according to the definition.- The recent war 
loan, for example, yields a revenue to the lenders, and, 
for all we know, may yield a revenue for centuries ; 
but the corresponding capital has been used for the 
most part in the destruction of life and property, and 
it would be too severe a strain on language, even with 
a plentiful use of those convenient terms " indirectly " 
and " fructifying," to include destruction by war under 
the term economic production, — and cases might be 


multiplied indefinitely. Take, again, the borrowings 
of various local authorities on the security of the 
rates. The loans will yield a revenue and so far 
rank as capital to the creditors so long as the cities 
and towns yield sufficient rates; but it is quite 
possible that, considered from the point of view of 
production, the *' capital " will very soon melt away 
altogether. Those examples show that the terms 
" loanable capital," and consequently " interest on 
loanable capital," are by no means so simple as they 
appear at first sight. And the deeper we carry the 
analysis, whether in theory or in practice, so much 
greater do the difficulties become. Kecently the 
highest legal talent of the country has been exercised 
in determining what is the nature of capital and how 
capital is related to dividends. 

In whatever way we regard it, the answer to the 
question " What is capital ? " presents difficulties in 
theory, in business, and in law. These difficulties 
may be partly surmounted and the nature and 
meaning of " capital " and " interest on capital " made 
clear by taking different cases. Capital, like money, 
has different functions. 

§ 4. Interest on capital divided into TROFiT-interest 
and LOAiii-interest — Of VRomT-interest. — The interest 
on capital as such, in which the money is only 
used as an intermediary, may be divided first of 
all into two great classes which we may call jprofit- 
interest and loan-mterest. 

Profit-inteiest arises in this way. The owner of 
any form of capital who employs it in production will 
expect to gain certain gross profits. He will expect 


something in the form of reward for his labour and 
enterprise, which economists call wages of management 
or superintendence ; he will also expect on the average 
of a mass of transactions or over a period of time to 
cover all sorts of depreciation of his capital — his gross 
profit must provide for insurance against risk; and 
besides these two elements he will expect something 
by way of interest. The three elements are best 
distinguished in the case of a joint-stock company. 
In this case the wages of superintendence appear in the 
shape of directors' fees and salaries ; the insurance 
against risk is represented by the reserve fund, or it 
may be by actual insurances under that name ; and 
the balance which goes in dividends to the shareholders 
represents the interest on their capital. This interest 
again differs according to the security — e.g.^ debentures, 
various preferences, ordinary shares, etc. ; but after all 
allowances there remains an element which may be 
called pure interest — that is, interest on capital in 
which there is practically no risk and no trouble of 
management, although the interest is, so to speak, 
produced in the business. If any industry gets into 
a depressed condition, it is quite possible that the 
gross profits may not yield any interest after allowing 
for management and depreciation, and, of course, the 
capital may disappear altogether; but over a period 
of years it may be said that the " productive capital " 
of the country yields, on the whole, a certain rate of 
pure interest besides the other elements in gross profit. 
§ 5. \^Ok^-int crest. — Zoa^i-interest on capital is 
considered from a point of view in which direct 
production is of a secondary or, it may be, of no 


importance. People may be unable or unwilling to 
employ their capital themselves, and they lend it to 
others, receiving so much interest for its use. In 
this case it is indifferent to the lender what use is 
made of his capital ; it may be wasted by an 
extravagant landlord or by an improvident government ; 
but so long as the interest is obtainable from other 
funds at the disposal of the debtor this makes no 
difference. The interest on large amounts of capital 
is paid out of the produce of rates and taxes, and 
cannot be considered as earned by the productive 
employment of the capital concerned ; and in other 
cases the interest is really paid out of other capital 
belonging to the debtor. 

If, however, we leave out of account for the present 
the case of foreign investments and consider one 
country in isolation, it is plain that all this interest 
obtained on loans must itself in some way be produced in 
the country. The /(?a7?--interest may in some cases be 
a simple transfer of ^rq^'^-interest, as in the case of 
various companies or of private firms, so far as they 
work with borrowed capital. This case is simple ; 
but the loan-intQiQ^t may also come, as already 
indicated, from other sources — from the general income 
of the tax-payers or from the gradual dissipation of 
other forms of capital. Zoan-interest of this kind 
— whatever form it may assume, that is to say if it is 
not obtained from the productive employment of the 
corresponding capital — is of the nature of a tax upon 
productive capital and industry ; and if all the capital 
of a country were advanced in unproductive loans of 
this kind the country would speedily be ruined. 


If the capital is sent for investment in foreign 
countries, the case is in some ways similar to loans 
for unproductive purposes at home. In this case 
only the interest is received by the lending country ; 
and thus from the national standpoint there is so far 
a reduction of income as regards the profits and 
wages which arise from the employment of capital in 
home industries. 

Consider now the causes that determine the 
direction of the employment of loanable capital. It 
is clear that after allowing for security, facility for 
investment, and other conditions, the rate of interest 
on all kinds of capital must tend to equality. 

§ 6. Interaction between the two rates. — Accord- 
ingly there must be a constant interaction between 
loans for productive and for unproductive purposes. 
If trade is flourishing, and gross profits, including 
^rq/i^interest, are advancing, capital is directed to- 
wards industrial concerns; and conversely, with a 
depression of trade and profit-interest declining, 
capital is turned to non-industrial loans or to advances 
to foreign states on which the yield is a little better. 

§ 7. Interest is a price and subject to the laws of 
prices — Competition and monopoly, — Interest for many 
purposes is best regarded as the price paid for the use 
of capital. And if .interest is once looked on as a 
price, it comes under the general principles determin- 
ing prices. In the course of progress the tendency of 
prices is to come under the influence of competition. 
And if we take a rapid glance over the actual history 
of industrial progress, we find that one of the most 
striking results is the substitution of the principle of 


competition for the principle of monopoly in the 
determination of interest. In old societies interest 
was usually regarded as immoral and sinful, because 
in most cases it represented what was extracted 
by the usurer from the absolute necessities of the 
borrower. Under modern conditions the rate varies 
principally with the security that is oJBfered, and not 
according to the particular necessities of the borrower. 
The borrower might be willing for his purposes to pay 
10 per cent, a-month; but if the security is satis- 
factory he may have to pay less than 5 per cent, a-year. 
§ 8. Widening of markets with progress. — Another 
principle that becomes prominent in the course of 
industrial progress is that prices are determined more 
and more by wider and wider markets. In older 
societies there were numbers of local markets, and 
prices were mainly determined by the local conditions 
affecting demand and supply. Under present con- 
ditions, for many " commodities " — using the term in 
an extended sense — there is a world-wide market. 
The prices of wheat, of cotton, of silver — to take but 
three instances — are determined by the conditions of 
demand and supply all the world over. A striking 
example was afforded by wheat in the year 1879. 
This year was the coldest of which there is any instru- 
mental record in these islands, and there was a great 
failure of the harvest. So easily, however, was the 
deficit met, that the price of wheat only rose to 53s. 6d., 
as compared with 51s. as the average of 1871-1880. 
Even at the beginning of the nineteenth century 
such a deficiency in the harvest might have doubled 
or trebled the price. 


The point of the illustration is this, that the price 
of loanable capital — that is, interest — in the course of 
industrial progress has also come to be subject to 
conditions of demand and supply all the world over, 
and no longer depends on local or even national 
markets. The rate of interest on loanable capital in 
this country depends, to say the least, very largely 
upon the rates that may be obtained in other 
countries ; and with every development of the means of 
communication, including the diffusion of knowledge or 
the extension of publicity in the world's great markets 
— with every increase in the security afforded by the 
advance of international law, and of the recognition by 
individuals and by governments of the sacredness or the 
compelling force of contracts, — loanable capital will 
come more and more under these great world- 

I proceed, now, to notice very briefly some of the 
principal causes affecting, first the supply, and next 
the demand, for loanable capital as distinguished from 
" money." 

§ 9. The supply of loanable capital — Production, — 
As regards the supply of capital, the causes may be 
divided into two groups. First, there are all the 
causes which tend to increase production or to 
diminish cost. A given amount of labour and also a 
given amount of coal will, with appropriate machinery, 
produce more than ever before, and, in all probability, 
this increase in the powers of production will continue. 
Again, tlie great improvements in transport, in security, 
and, I may add, in knowledge, have opened up abundant 
new sources for supplies of various forms of raw 


material, including the raw material of food. This 
process seems also likely to continue, and man's power 
over nature to be further extended to a great degree. 
There is also to be considered the continuous utili- 
sation of waste products, and the adoption and 
extension of multitudes of economies. And perhaps 
the greatest cause of all — if we are to consider 
the world's supply of capital — is the advance of all 
the other nations on the roads made by the pioneers 
of civilisation. China may follow Japan, as Japan has 
followed the West. 

§ 10. Effective desire of accumulation. — But whether 
this enormous increase of wealth will be turned into 
" capital," or will be consumed directly and unproduc- 
tively, depends on a second group of causes. These causes 
are mainly moral and intellectual, but they are equally 
real and important. Such, for example, are the causes 
which are summarised under the phrase the " effective 
desire of accumulation." There can be no doubt that, 
taking a wide survey, these causes tend to increase 
in force. The people in civilised states look further 
into the future and they make more provision for the 
future. This is shown not only by the growth of all 
forms of insurance, but by the growth of education 
and of morality, and by the desire to rise in the social 
scale. The better members of the lower social classes 
strive more and more to rise into the higher, and 
one potent means is by saving a certain amount of 

But it is not so much on the moral as on the 
intellectual side that the creation of capital is affected 
by modern progress. People are willing to wait 


longer and to take more roundabout methods to secure 
their ends, and in the last resort that means they put 
more and more wealth into the form of capital. 

§ 11. Security. — The great cause affecting the 
accumulation of capital that always appears in every 
part of the inquiry is security. Security to enjoy or 
to dispose of the fruits of saving is a necessary con- 
dition to the creation of capital. Under present 
conditions the increase of security as afifecting the 
accumulation of capital may be specially observed in 
two ways. First, in the countries that are in the van 
of progress more and more undertakings are conducted 
on a sound basis. We are apt to lay too much stress on 
striking failures or gigantic frauds, but there is no 
question that relatively the losses of business are less 
than ever before, or the losses that occur are more 
easily repaired. The ordinary increase of capital in 
this country has been estimated at 200 million pounds 
per annum."^ 

But, seco7idly, the influence of the increase of 
security is still more noticeable in backward and new 
countries. More and more countries are offering 
security for the creation of capital, and with the 
growth of security there is at once an increase in 
productive power. Thus, from whatever point it is 
regarded, there is no question that, as far as supply 
is concerned, the tendency is for a continuous and 
considerable increase of capital. 

§ 12. Demand for capital, and. first for unpro- 
ductive purposes. — Let us now consider demand, and, 

* Such estimates are necessarily very rough, hut they suffice for 
comparative purposes. See Giffen's Qrowth of Capital. 


in the first place, the demand on the part of unpro- 
ductive consumers. Amongst these the most important 
are the governments of the world, both national and 
municipal. The national debts of the world are said 
to have a par value of about £6000 millions sterling, 
and have mainly been incurred for unproductive pur- 
poses, especially for war or for armaments, and 
accordingly the interest is not derived from the 
productive employment of the original capital. Local 
debts to a greater extent represent productive capital, 
but still in this case also a large part is unproductive 
— that is to say, the loans do not produce their own 
interest. On the other hand, however, a large part 
of this expenditure, though classed as unproductive, in 
reality adds greatly to the efficiency of a nation as 
regards production, and also adds to those moral and 
intellectual qualities of the people which lead them to 
provide more and more for the future — that is, to 
create capital. 

§ 13. Demand for productive purposes. — But, second- 
ly, the demand for capital may be directly for pro- 
ductive purposes, and this demand has increased 
enormously of recent years through the growth of 
joint-stock companies, which now in this country 
exceed in importance private firms. The spread of 
companies gathers together masses of capital which 
was formerly wasted or kept idle for want of facilities 
for investment, and accordingly this increased demand 
largely creates the corresponding supply. 

And as regards the demand for productive purposes 
generally, it may be observed that every new 
demand on a sound basis implies a certain surplus in 


the future — that is to say, the ultimate effect of 
borrowing for production is a further increase of 

§ 14. Forecast. — It appears, so far, that the supply 
of capital is likely to outstrip the demand, and that the 
rate of interest on capital will tend to fall. And this 
general conclusion is strengthened by another considera- 
tion, the influence of which is not at first sight so 
obvious. There is to be considered the growth of 
population. Of the great civilised nations it is only 
in France that there appears to be an absolute 
diminution in the sense that the deaths exceed the 
births, but in other countries the rate of increase has 
fallen off, and the eminent French economist and 
statistician, Leroy-Beaulieu, has plausibly maintained 
such a decrease is the natural result of democracy. 
If, however, capital increases faster than population, 
the natural result is for wages to rise and interest to 

§ 15. Effects of war. — On the other hand, there is 
the possibility of a great war, which would directly 
increase the demand for capital and also tend to 
diminish the supply. It would also indirectly, by the 
shock to security, tend to raise the rate of interest. 
The subject, however, is too problematical for present 
consideration. I venture to observe, however, that the 
recent fall in the price of first-class investments, or, 
what is the same thing, the rise in the yield, has been 
too readily ascribed to the South African war. The 
effects of that war, whether as regards the demand or 
the supply of capital or any shock to security, do not 
seem of sufficient magnitude to account for the rise in 


interest.^ It is difficult to see why the Boer war 
should have so great an effect whilst the Franco- 
German war had relatively none. 

I am inclined to think a more potent factor is the 
greater industrial demand and the widening of the field 
for investment. The gilt-edged securities have lost part 
of their monopoly or their scarcity value, and there has 
been a displacement of old capital and an investment 
of new in all kinds of undertakings which formerly 
were not available. 

Thus loan-interest has moved in sympathy with 
profit-interest, and the rise is due, not to any abnormal 
increase in the demand for unproductive wars, but 
to the increase in the yield of productive capital. 
The last four years on the whole have been years of 
unexampled prosperity. 

§ 16. Interest on loanable money. — I have dealt at 
such length with the rate of interest on '' capital " that 
I have little time to consider the case of interest on 
loanable " money." The most interesting questions, 
however, in connection with this second case are perhaps 
better treated in the subject of Commercial Crises 
to be taken up in the next chapter. For the present 
it must suffice if I indicate very briefly the leading 
ideas; for a fuller statement and for technical 
illustrations you have Bagehot's Lomhard Street and 
Mr Clare's Money Market Primer, and, I may add, 
the admirable little book of Professor Dunbar on 

We may begin by saying that the value of money, 

* The slight effect on interest of the declaration of peace has 
confirmed this view. 


in the sense of the rate charged for advances of money, 
depends on the supply and the demand. But the 
term " money," as we saw in the first chapter, is a very 
variable and elastic term, and we must always consider 
the particular monetary function or functions involved. 
The " money " we are now concerned with must be 
either legal tender or by custom or habit it must have 
the force of legal tender. The special function of the 
money of the money market is to provide means for 
settling bargains made in terms of money. The money 
that is strictly legal tender is far too small in amount 
to make these settlements. The whole stock of legal 
tender in the United Kingdom, including Bank of 
England notes (issued against securities), probably does 
not exceed 126 million pounds.^ Of this, again, more 
than half is in actual circulation from hand to hand, 
leaving some 50 or 60 million pounds for banking 
purposes, and of this amount generally more than a 
quarter is held by the Bank of England. At the date 
of this calculation the sum due by the banks of the 
United Kingdom on deposit and current accounts was 
650 million pounds — that is, ten times the amount of 
the legal tender available. This is what is meant by 
saying that " bank " money consists for the most part 
of credit; it is based on legal tender, it represents 
legal tender, and on demand it is convertible into 
legal tender ; but it is not itself legal tender, and the 
possibility of banking rests on the fact assured by 
experience that the demand for legal tender in the 
ordinary course of things will be relatively small, and 
can be calculated. Accordingly, the banks keep in 

• Clare's Primer, p. 49. 


the way of till money just as much legal tender as 
they think will be required ; and just as the proportion 
of the kinds of legal tender required — silver, gold, 
notes — is known by experience, so also is the total 

It is only putting the same fact in another way 
when it is said that in most trade transactions pay- 
ments are made by cheques or bills. In the words of 
Mr Clare, " Cheques and bills form the principal 
currency of this country." A reference to the 
Clearing-House Keturns shows the magnitude of the 
transactions, and these returns furnish the best test of 
the activity of trade. 

§ 17. Importance of legal tender. — But although 
legal tender forms only a relatively small part of 
the currency, it is an absolutely essential part. A 
certain amount is necessary for wages, retail trans- 
actions, railway fares, and various payments for which 
cheques — at least ordinary cheques — are not available. 
In ordinary times, as I said, the amount of legal 
tender required can be readily calculated and readily 
obtained, but as soon as the ordinary conditions change 
there is a change in the demand for legal tender. 
Thus an increase in the volume and activity of 
trade increases the demand directly, and any shock 
to credit by diminishing the use of cheques and bills 
indirectly increases the demand. In extreme cases 
an internal drain of this kind may lead to a com- 
mercial crisis. 

§ 18. Supply of legal tender inelastic. — It will be 
seen, then, that whilst the supply of legal tender is 
practically limited and inelastic, the demand is liable 



to variations, eveu if we consider only internal trade. 
But the principal demand for legal tender, or rather 
for the gold on which it is based, is the foreign 
demand. A foreign demand may arise suddenly in 
the most unexpected way, and it may be such that it 
can only be met by the export of gold. It is in this 
connection, as already pointed out, that movements in 
the foreign exchanges are of general importance. The 
Bank of England seeks to protect itself, and also to 
attract gold from other countries, by raising its rate. 
And since the Bank of England practically holds the 
only available reserve of gold for foreign demands, the 
proportion of its reserve to liabilities is a factor of the 
greatest importance in determining the rate. 

§ 19. The hank rate and the marlcet rate. — For 
simplicity, I have spoken as if there was at any time 
only one rate charged for advances of money. It 
is hardly necessary to point out that the bank rate 
may differ from the market rate, and that in 
practice there are great differences in market rates — 
according to the security offered, the class of business, 
the condition of the loan, and other circumstances. 

§ 20. Interaction of interest on capital, and interest 
on money as such. — Although the rate of interest on 
capital as such is best distinguished from that on 
money as such, there is an interaction or a sympathy 
between the two rates. If the rates obtainable for 
money are low, purchases of first-class securities are 
increased, partly for the better interest and partly 
for the probable rise. A low rate also specially 
stimulates speculation for the rise on the Stock 
Exchange, if other conditions are favourable, But a 


rise in the price of securities, with fixed interest, is 
the same as a fall in the rate of interest. Conversely, 
with higher rates for money as such, securities are sold, 
and the fall is again hastened by Stock Exchange 
speculation. Still, it is evident that a large part of 
the holdings of banks is of the nature of a docu- 
mentary reserve, and although speculation on the 
Stock Exchange, whether for the rise or fall, is 
generally affected by the bank rate, it depends much 
more on other influences. Thus for long periods 
there may be a considerable difference betvreen the 
two rates — namely, the interest on capital, and the 
interest on money as such. 

§ 21. Probable effects of great gold discoveries. — I will 
conclude with a brief notice of one point of special 
interest at the present time. We have seen the 
fundamental importance of the gold reserve in the 
Bank of England, and of the effects of movements in 
that reserve on the rate of discount. It might then, 
at first sight, be thought that the annual supply of 
gold from the mines would be of fundamental import- 
ance: so that with a falling off in supply discount 
rates would rule high, and with an increase there 
would be a fall. There is, however, no such simple or 
necessary connection. We may take for illustration 
the recent changes in the production of gold. 

During the last quarter of a century the supply of 
gold has doubled, and it is quite possible that during 
the next quarter it may again be doubled. The ques- 
tion is. What will be the probable effect on the rate of 
interest on loanable money ? The answer, I think, 
depends on the way in which the supplies are used. 


If a large part of the new gold were constantly added 
to the money market, so far the increase of supply 
would tend to lower rates. But the further question 
arises, Who is to keep the gold in the market ? 
The gold of itself is as barren a metal as ever it was, 
and it is also as heavy and as inconvenient for large 
payments. The banks, including the Bank of 
England, will not be at the expense of keeping more 
gold than they require as reserve, and people will not 
use more than they are accustomed to as currency. 
Thus the new gold must be forced into circulation, 
not necessarily in this country, but in some part of 
the commercial world. The natural effect will be to 
raise prices, and in that way to stimulate trade. This 
stimulus to trade may again lead to a rise in the rate 
of discount. 

Similarly, a falling ofif in the supply of gold tends 
to lower prices, and so to depress trade, and in that 
way indirectly a diminution in the production of gold 
may lower the rate of interest, as was the case 
twenty-five years ago. There are, no doubt, as in 
all these monetary questions, other counteracting and 
disturbing elements. The depreciation of silver had 
very great effect, in my opinion, in lowering prices, 
and also in promoting the useless hoarding of gold by 
France and other countries. It is quite possible, now 
that silver has lost its monetary influence, with the 
increase in the natural supplies of gold, there will be 
also some unlocking of these great hoards, and thus a 
still greater rise in general prices. Such a fall, 
however, in the exchange value of gold as is indicated 
by a rise in general prices, may be accompanied by a 


rise in the rate of interest, unless counteracted by the 
other causes indicated. 

§ 22. Practical illiistration. — In conclusion, this case 
may be used to illustrate the general argument of this 

At first sight nothing seems more natural than to 
say: Interest means the price paid for the use of 
money ; gold is money, and therefore if the supply of 
gold is increased, the supply of money also is increased, 
and therefore the rate of interest will fall. This argu- 
ment, however, which at first sight seems so simple 
and plausible, on analysis is full of difficulties, not to 
say full of fallacies. 

We must first of all distinguish between interest 
on "capital" and interest on "money." If we take 
account of all the capital of the world on which interest 
is paid, the gross total must be reckoned by thousands 
of millions sterling. This interest arises in many 
ways : it may be definitely earned in production or in 
the case of industrial companies, or it may be paid out 
of taxes, as in the case of the interest on national 
debts. But as the result of competition, what may be 
called the pure interest — that is, after allowing for 
risk, depreciation, management, etc. — the pure interest 
on all these multitudinous forms of capital tends more 
and more to equality, or the differences become less and 
less throughout the commercial world. 

Suppose, then, that the amount of gold is increased 
by 50 million pounds a-year, what is this 50 million 
pounds added to these thousands of millions ? It is 
evident, then, that the argument, from the increase of 
the supply of " capital," falls to the ground. 


If, however, we carefully separate " capital " from 
" money," it is no doubt true that the amount of loan- 
able money is of much smaller dimensions. But even 
loanable money embraces more than legal tender, and 
legal tender includes more than gold. The advances 
made by banks consist of a relatively small amount of 
legal tender and a still smaller amount of gold itself. 

Why, then, should an addition to the supplies of 
gold from the mines lower the rate of interest on loan- 
able money ? It is well known that during the last 
twenty-j&ve years the Bank of England rate has been 
for months together at the official minimum of 2 per 
cent., and the corresponding market rate has been lower 
still. And it is noteworthy that the rates were lowest 
when the annual production of gold was lowest. No 
doubt the adequacy of the ultimate reserve of gold 
held by the Bank of England is of the greatest import- 
ance to our credit system ; but the amount of that 
reserve has very little connection with the annual pro- 
duction of gold, and the annual production of gold 
has still less connection with the rate of interest. 

[Note. — Compare Principles of Political Economy^ 
vol. ii. chap, xxii.] 



§ 1. Monetary and commercial crises distinguished. — 
The title of this chapter is " Commercial Crises," but in 
accordance with common practice the term is used as 
also covering crises that are in the main monetary or 
financial. As a matter of history, in most cases, 
though not in all, crises have been both commercial 
and financial. For purposes of analysis, however, it is 
best to consider the two cases separately. 

I shall deal first with monetary crises, and for 
guidance in this part of the subject I shall ask you 
to accept two principles, the importance of which has 
been abundantly proved by experience. 

§ 2. In monetary transactions ultimate solvency not 
sufficient. — The first principle is this, namely — 

In banking, and more generally in monetary 
transactions, ultimate solvency is not sufficient. No 
one doubts for a moment, and even in the most severe 
crises no one has doubted, the ultimate solvency of 
the Bank of England. Of this one very striking 



proof may be offered. In each of the three great 
crises which followed the passing of the Bank Charter 
Act of 1844 — namely, in 1847, in 1857, and in 1866— 
this Act was suspended by the authority of the 
government of the day. Now what is the meaning of 
the suspension of the Act ? In effect it amounts 
simply to giving permission to the Bank of England to 
issue more notes without a corresponding increase of 
gold. If there had been any doubt of the ultimate 
solvency of the Bank of England, the remedy would 
have seemed like the joke in Furwh, in which the 
young lady meets an overdrawn account by sending 
her banker another of her cheques payable to himself 
by himself. But, as a matter of fact, the suspension of 
the Act, in two cases indeed the mere announcement of 
the suspension, was sufficient to restore confidence and 
allay panic. 

Again, to come to our own times, for a long time 
past the Bank of England has held a reserve of gold — 
for the notes in the banking department can be 
immediately converted into gold in the issue depart- 
ment, — the Bank has held a reserve equal to 40 or 50 
per cent, of its deposits. In any ordinary bank such a 
proportion of reserve would seem ridiculously large, 
even if the term reserve were extended to cover much 
more than gold. But the Bank of England is the 
bankers' bank, and although in banking cash and legal 
tender may be economised to a wonderful degree, in 
certain cases for certain purposes they are essential. 
Sometimes nothing but gold itself will suffice, and 
practically the only reserve of gold is in the Bank of 


§ 3. Deferred convertibility and suspended conver- 
tibility. — The second principle I ask you to apply is 
really only a special case of the first — namely, that 
deferred convertibility is not the same thing as 
immediate convertibility, and suspended convertibility 
is not the same thing as payment on demand. The 
case which used to be of most importance was the 
case of bank notes. For a long period bankers' 
advances were made for the most part in bank 
notes, and even fifty years ago it did not seem 
so preposterous as it would now to suppose that 
monetary crises would be avoided by the proper regu- 
lation of the issues of bank notes. That was the idea 
by which the Bank Act of 1844, and the corresponding 
Act for Scotland of the next year, were passed. 

§ 4. Possible over-issue of bank notes, — The framers of 
the Act of 1844 did not mean simply to secure the 
absolute convertibility of the notes ; above all, they 
wished to prevent excessive issues. Such excessive 
issues, they supposed, caused an inflation of credit and 
an inflation of prices, and ultimately led to a crisis. 
This idea was the subject of a prolonged controversy, 
which only ceased because bank notes came to be a less 
and less important part of the credit system, and the 
Bank of England notes in active circulation positively 
declined in spite of the growth of trade and popula- 

§ 5. Same principle applicable to other forms of 
credit. — But the fundamental idea is by no means 
dead, though the application must now be different. 
Those who opposed this " currency principle," as it was 
termed, or minimised its importance, maintained that 


if the notes were convertible on demand there could 
not be an excessive issue. To which the supporters of 
the stringent limitation of issues by law replied, in 
effect, that the notes might not as a matter of fact be 
presented for payment — that as prices rose, more 
might be circulated, and thus that a crisis would 
eventually be more severe. This view gained the day, 
and, as I said, the Bank Act of 1844 was passed to 
prevent crises by limiting the issues of bank notes. 
Deferred convertibility is usually taken to mean at the 
option of the debtor ; the peccant banker undertakes 
to cash his notes as if they were letters of exchange 
payable after so many days or months. Deferred 
convertibility of this kind was soon shown to be full of 
danger, witness Scottish banking in the eighteenth 
century. But there may also be deferred convertibility 
simply through the inaction of the creditor ; the point 
is, that if the notes are presented for gold, gold will be 
given, but they are not, as a matter of fact, presented. 
And indeed the profit of banking for a long time 
depended mainly on this deferred conversion. 

This source of profit may be quite sound in practice, 
as is proved by experience. At the same time, how- 
ever, every civilised State has deliberately imposed 
limits on the issues of bank notes ; though the 
limitation has been achieved in very different ways — 
as, for example, it is different in England and in 
Scotland. Time will not allow me to enter into the 
reasons in detail, but the reference to the universal 
consensus of opinion ought to be sufficient. Con- 
vertibility in itself is not thought to he a sufficient safe- 
guard against the over-issue of hank notes. 


But what, it may be asked, is the bearing of the 
argument on commercial crises under present con- 
ditions, when not only issues of bank notes are 
limited, but the very use of notes is of minor 
importance ? "^^ The answer is, that the same prin- 
ciples apply in the case of deposit banking and 
cheques ; the notes have been taken for illustration 
because they are the simplest form of credit 

§ 6. Banks of deposit and banks of issue. — In 
deposit banks, just as in banks of issue, in the first 
place ultimate solvency is not enough ; and in the 
second place the mere fact that cheques are all 
nominally payable in legal tender on demand is not 
enough to prevent the unwise extension of credit, and 
as a consequence excessive speculation and inflation. 
And yet in this country bankers are practically left to 
themselves in the management of their deposits, 
advances, and reserves ; and whilst the issues of notes 
are so strictly regulated, the use of cheques is, from 
the same point of view, altogether unregulated. 

In some countries deposit banking has been the 
subject of legal regulation — notably in the United 
States — and the want of regulation in this country 
does not show that there are no dangers in freedom. 
The system has grown up under various influences 
instead of being a logical application of principles. 
The absence of legal regulation may show either that 

* " The balance-sheets for December 1887 of six English banks of issue 
selected at random show liabilities of £200,000 on notes (compared 
with £360,000 in 1844) against no less than seven and a half millions 
on current and deposit accounts." — Clare's Money-Market Primer, 
p. 15. 


the banks are to be trusted if left to themselves, or 
that legal control is too difficult to manage or to 
introduce. Let me again refer to the Bank of 
England and the account of its functions and position 
as given in that classic work, Bagehot's Lombard 

§ 7. Deposit hanks subject to little legal control. — 
The essence of the argument is to show the delicacy 
and the danger of the present system. No writer has 
ever made so clear the narrow foundation of our 
present credit and banking system, and the important 
part played by the Bank of England, which, strictly 
speaking, is not a State bank, and the governor and 
the directors of which are not bankers, but merchants 
engaged in other businesses. And yet the moral of 
Bagehot's argument, his general practical conclusion, is 
not that law and government should at once put an 
end to such an anomalous state of things, but simply 
that public opinion should impress on these directors a 
sense of responsibility, and that some changes should 
be made in the appointment of the governor and 
directors so as to admit of greater permanence in the 
executive, and an admixture of trained bankers. But 
of legislative control and legal rules for the manage- 
ment of the reserve and deposits, there is not a word. 

Well, then, the mere fact that deposit banking is 
left practically free in this country does not show that 
it is not liable to danger, but simply that under 
present conditions the danger is not such as can be 
met in fact by legislative control. The simple truth 
is that, as in so much of our political and commercial 
system, so in the most important part of our bank- 


ing, we rely on the system of national liberty, and 
we trust more to historical growth than to the logical 
application of principles. 

§ 8. Causes of financial crises — Instcfficient reserve. — 
A financial crisis may arise, broadly speaking, in 
two ways. In the first place, the ultimate reserve 
may prove insufficient to meet a sudden strain. 
Such a strain may arise from events occurring in some 
foreign country — the outbreak of war, a political 
revolution, or it may be the failure of some foreign 
banking system. In the past the reserve kept 
was inadequate, and in times of peril it was mis- 
managed. This mismanagement of the reserve, if not 
the cause, was an aggravation of crises. At present 
the amount is larger, and measures of precaution are 
taken much sooner; and last, but not least, in times 
of pressure assistance is afforded more readily when the 
ultimate security is undoubted. In fact, under present 
conditions, it seems at first sight hardly conceivable 
that even a foreign drain could be dangerous to the 
Bank of England, whilst any home drain, it may be 
thought, could be met by the suspension of the Bank 
Act and the issue of Bank of England notes. 

But the stability of our present system is by no 
means perfect. It is now more than a quarter of a 
century since Bagehot described the dangers of our 
one-reserve system, and yet at this very time the 
London bankers are still discussing the best means of 
diminishing these dangers. There is, fortunately, no 
question that as regards the management of reserves 
— especially the reserve of the Bank of England — 
there has been immense progress since 1866. So 


great, indeed, has the improvement been, that, in spite 
of the Baring crisis, it is seriously maintained by good 
authorities that crises from this source are no longer 
to be feared. Seeing, however, that it is little more 
than ten years since the Bank of England was borrow- 
ing gold from the Bank of France and from Eussia, 
this complacency is rather premature. In these days 
nothing is secure from the attack of combined specu- 
lation. So far back as 1866 Overend & Gurney tried 
to embarrass the Bank of England by the sudden with- 
drawal of three millions. It is, at any rate, not beyond 
the range of possibility that the banking system of 
this country might be attacked by some great specu- 
lative combination in what is generally considered its 
most vulnerable part. 

§ 9. The credit superstructure. — But there is 
another source of danger. The danger may arise, 
not in the reserve, but in the credit superstructure. 
No doubt, here also banks have learned from experi- 
ence, and they are much more prudent than was 
formerly the case. Advances are made on better 
security — in the widest sense of the term — and the 
funds of the banks are kept more under control. But 
in a system which rests largely on the good faith and 
the sound judgment of hundreds and thousands of 
people, how can we be sure that some gigantic fraud, 
or at least some disastrous error of judgment, will not 
be perpetrated ? It is on this point that the warning 
of history is most clear and convincing — and not 
only ancient history, but history that has been 
imprinted on the minds of living men. 

Even granting that the management of the reserves 


were perfect, that is only part of the business. There 
is also the danger of excessive competition for business, 
and the advance of the funds of the banks or of one 
or more of them beyond the proper range of banking 
securities — there is the danger of over-confidence, of 
ignorance, and of fraud. Owing to the close inter- 
dependence of every part of our credit system, any 
failure on a large scale may bring down firms that 
are in no way to blame. No doubt the businesses 
that are weakest fail the soonest, but the strongest 
may be unable to bear the strain. And the losses 
incurred may be such that even the ultimate solvency 
is not secure. It is true that in banking, conducted 
on the principles confirmed by experience, there ought 
to be no danger of ultimate solvency. A bank can 
apply almost indefinitely the method of dividing the 
risk, just as an insurance company may itself insure 
against certain risks by re-insurance. It is true, 
however, that the principle of insurance is not always 
so easy of application in banking as it is in life insur- 
ance. In times of a great plague the life insurance 
companies have to meet many claims for deaths, but 
in times of a great panic banks must meet claims of 
people who think they are going to die. As we all 
know, banks have failed in the past and in all prob- 
abihty will fail in the future, though not to the same 
extent. The principal danger of banking arises at 
present, not with reference to ultimate solvency, but 
with reference to immediate demands in times of 
sudden discredit or alarm. And in this connection it 
may be observed that although the shock only lasts a 
short time the recovery may be slow, and during the 


process of recovery a strain may be imposed on 
industry generally — that is to say, a crisis financial in 
origin may in its effects become commercial. 

§ 10. Causes of commercial crises — Over-speculation — 
Historical cases. — It is time, however, to observe 
that crises may arise from causes that are primarily 
commercial and in which the financial results are 
secondary. I pass on, then, to consider commercial 
crises in the more special sense of the term. If we 
look back on the history of commercial crises, we often 
find that they begin with a hond-fide expansion of 
trade and industry. Such an expansion may be due 
to the adoption on a large scale of new methods of 
production and of transport. Thus, at the end of the 
eighteenth century, so many changes were introduced 
that the period is often spoken of as the Industrial 
Eevolution. The crisis of 1793 was preceded by a 
bond-fide expansion of trade consequent on the increased 
use of machinery for manufacture and improvement 
in transport by the greater use of canals. 

This hond-fide development of industry was accom- 
panied by over-speculation and the undue extension 
of credit. The crisis was precipitated by political 
causes, especially the war with France. It was 
marked by many failures of country banks and a dis- 
trust of credit documents. The difficulty was met to 
some extent by the issue of exchequer bills, but 
ultimately a continuance of the same unfavourable 
conditions led to the suspension of cash payments by 
the Bank of England, and Bank of England notes 
remained inconvertible till 1819. 

The principal cause of the crisis of 1847 was 


mainly due to the great development of railways. 
Twenty years before the capital expenditure on 
railways, then in their infancy, was less than one 
milhon a-year. Even in 1842-43 the capital expendi- 
ture was only about 4^ millions ; then in 1846 the 
amount authorised by Parliament had risen to 132 
million pounds. This actual authorisation of capital 
for railways was accompanied by a still greater 
amount of speculation. It has been stated that in 
1845 — the preceding year — the market value of 
the various new schemes which were represented by 
letters of allotment was not less than 500 million pounds. 
The speculative rise in shares was enormous. In the 
Leeds and Thirsk Eailway shares with £2, 10s. paid 
rose in a few months to £23, 10s. — i.e., nine times 
the value of the amount paid ; in another case shares 
with £4 paid in January 1845 were selling at £4, 10s., 
and in September at £42, 15s. — again a rise of more 
than nine times. Here again, though the crisis was 
commercial in origin, it was in its secondary symptoms 
financial. The reserve of the Bank of England was 
reduced to £1,600,000, consols fell to 77f , and many 
banks failed. In the end the financial , crisis 
was stayed by the suspension of the Bank Act of 

I have taken these two crises for illustration, 
because the commercial causes in which they originated 
were not only perfectly sound, but were destined 
ultimately to increase enormously the industrial power 
of the nation. The development of machinery, and 
the improvement of transport and the means of 
communication, were unquestionably two of the 



principal causes of industrial progress in the nine- 
teenth century. 

In a case of this kind, which begins with hond-fide 
causes of prosperity, the prosperity passes into 
inflation, and the inflation into a crisis, followed by 
a depression, simply because speculation, aided by 
credit, anticipates too rapidly the realisation of the 

§ 11. Similarity in development. — The process after 
the preliminary stages is invariably the same. People 
begin by investing their money in something which 
they think will yield a good return. This is un- 
questionably so far legitimate enterprise. There 
would be no progress if the owners of capital did 
not take a certain risk in new undertakings. The 
next step is that the value of the " new thing " — 
whatever it is — the value rises. And then people 
begin to buy the thing, not with the idea of getting a 
good yield from it in the shape of income of some 
sort, but of getting an extravagant profit by a further 
rapid rise in value. Very soon the original object is 
altogether lost sight of, and prices are paid which 
under no conceivable circumstances could be justified 
by legitimate business. Then the speculation naturally 
spreads to other things — many of them hopelessly 
unsound from the beginning. If a general speculation 
of this kind is aided by a system of credit that is 
itself unsound, or at any rate not properly under 
control, the inflation is pushed to greater extremes 
than would otherwise be possible. Bad speculation 
feeds on bad finance. Some speculators, however, 
are more far-sighted than others, and some credit 


institutions are more prudent with their advances ; 
speculation for the fall takes the place of speculation 
for the rise ; the fall becomes an avalanche ; good 
and bad are mingled together, and the inevitable crisis 
is followed by a period of depression of trade and 
contraction of credit. 

§ 12. The tulip mania. — Economic history is full 

of examples of speculation of this kind; sometimes 

it is purely local and temporary, at other times it 

seizes a whole nation — it may even affect the whole 

commercial world; it may be prolonged over a 

considerable time, and the collapse, when it occurs, 

is all the more redoubtable. Let me recall one or 

two famous examples. About the middle of the 

sixteenth century a German received a present of 

some tulips from Constantinople, and the flower soon 

became very popular, especially in Holland. The 

tulip was discovered to be capable of great variation, 

and especially amenable to artificial cultivation and 

experiment. For nearly one hundred years this plant 

was cultivated with great success in Holland ; and 

the growth of tulips became a very profitable and 

highly artistic industry. At last the trade became 

too profitable, and the prices of coveted specimens 

rose to great heights, and in the year 1634, to quote 

the pithy description of an old writer, " the whole 

Dutch nation went mad about tulips." Ordinary 

trades were neglected for growing tulips ; then people 

began buying the bulbs to sell again at a profit ; 

prices rose every day, and in the course of a year 

specimens of single bulbs fetched £300, £400, and £550. 

Then a speculation for the fall began ; roots were 


sold by those who did not possess them, more were 
sold than were in existence, and perhaps the first 
specimen of a " corner " was when a number of 
tulips had been sold of a kind of which there were 
only two specimens in the market. 

This speculation attracted attention in all the ex- 
changes in Holland, the infection spread to other 
countries, and large sums were remitted to Holland for 
speculation in tulips. At last — but not till 1636 — 
prices reached their climax, and a panic ensued on 
forced realisations which brought ruin to thousands, 
and many years passed before the force of the shock 
was spent. Yet even in this tulip mania there was a 
basis of reality. The growth of bulbs of all kinds 
became an important Dutch industry, and is so to 
this day. The interest of the example lies in its a 
'priori improbability. The subject of the speculation 
is a new kind of flower, and the country that was 
afflicted with the mania was the country of the sober- 
minded, phlegmatic Dutch. 

§ 13. Other speculative manias. — The greatest specu- 
lative manias on record, with which the nineteenth 
century has nothing to compare, arose in the first 
quarter of the eighteenth century — the South Sea 
Bubble in England, and the Mississippi scheme and 
the speculation associated with the name of John Law '^ 
in France. The greatest and most picturesque of all 
speculators was John Law, and there is little doubt 
that he was a man of great financial genius, and that 
his schemes, especially his great Bank, only proved 

*Tho essay ou " Jolm Law and the Greatest Speculation Mania on 
Record," in my Money and MoiiUary Problems (6th ed.), p. 166. 


unsound when they went beyond his own control. 
Even the period of the South Sea Bubble saw 
the promotion of some of the companies which have 
proved the most prosperous of any on record — as, for 
example, the New Eiver for supplying London with 
water. ' 

Facilities for speculation in recent times have no 
doubt been largely increased by the growth of joint- 
stock enterprise, especially after the adoption of the 
principle of limited liability. The possibilities of 
speculation have been further increased by the 
enormous expansion of credit, by the great improve- 
ments in the means of communication, by the tele- 
graph, and by the extension over a wider and wider 
area of dealings, not only on the stock exchanges, but 
on all the markets for important commodities. Nor 
can we suppose that in the course of two or three 
centuries there has been a fundamental change in 
human nature ; so far as human nature is concerned, 
a South Sea Bubble might begin to-morrow ; the ele- 
mentary passions are as strong as ever, including the 
love of gain and the love of gambling ; probably, 
indeed, so far as the mere desire or the mere greed is 
concerned, the passion is at present stronger than in 
many former times when speculation became rampant. 

§ 14. Ofher causes — Excess of fixed capital. — Al- 
though, however, both history and theory point to 
excessive speculation as the principal cause of crises, 
there are other causes which are too important to be 
passed over. The whole of modern industry is ex- 
tremely complex, and the various parts are inter- 
dependent, and the whole organisation is extremely 


delicate. Accordingly, any great disturbance in the 
methods of production, and any dislocation in any of 
the parts, may indirectly affect the whole system. A 
great conversion of circulating capital into fixed 
capital involves a disturbance of this kind. It may 
happen that more of the fixed capital is created than 
there is any effective demand for, and also that not 
enough circulating capital is left for the ordinary 
business of the country. In such a case as this, even 
if there is no crisis in the sense of a financial panic, 
there is a period of inflation, followed by a more or 
less prolonged depression. And in all probability this 
creation of fixed capital will be accompanied by ex- 
cessive speculation in the corresponding companies — 
e.g., in railways, mines, or it may be even in land 
itself. The present depression in Kussia is due to the 
excessive creation of fixed capital, and that in Germany 
is also associated with a too rapid industrial develop- 

S 15. Over-production. — Again, there is the 
possibility of general over-production in the sense 
that markets become over-stocked, production becomes 
unprofitable, and labour finds less employment. 
Under modern conditions a rise in prices and profits 
in any one great industry not only stimulates 
production in that industry, but the movement spreads 
from trade to trade through the expenditure of the 
extra profits and wages, and the whole production of 
the country or of the world is carried on at a higher 
pressure. Theoretically it may be argued, as by J. S. 
Mill, that general over-production is impossible, that 
commodities pay for commodities, that the more there 


is produced the more there is to exchange. But this 
theory implies a perfection in the methods of 
distribution or the possibility of exactly adjusting 
supply to demand, and of turning capital into 
new modes of employment, that does not exist in 

§ 16. Raw materials and the seasons. — A general 
cause, which used to be of the first importance, is 
found in disturbances affecting the production of raw 
material, including food. Under old conditions, when 
each country relied mainly on its own harvests, a 
series of bad harvests caused universal depression, 
except to the farmers, who were more than 
compensated by the rise in prices ; and a series of good 
harvests caused general prosperity, except to the 
farmers, who lost more by the fall in prices. The 
influence of the harvest in England used to be so great 
that the price of consols was affected by the weather. 
Under present conditions the area of supply has been 
so extended that the deficiency in one part can be met 
by the abundance of another, and in any case so much 
is produced, and of such variety, that as regards food, 
apart from a general war, there is little fear of any 
real scarcity. With regard to raw material of various 
kinds there is less room for substitution, and there 
may be real scarcity, as we have experienced lately as 
regards coal, and formerly as regards cotton. It was 
the consideration of the importance of the supplies of 
food and raw material which led Professor Jevons to 
formulate what is known as the sun-spot theory of 
commercial crises — the name is rather startling, but 
there is nothing unreasonable in the idea. 


§ 17. The sun-spot theory. — " It seems probable," 
argues Jevons, " that commercial crises are connected 
with a periodic variation of weather affecting all parts 
of the earth, and probably arising from increased 
waves of heat received from the sun at average 
intervals of ten years and a fraction." Cycles of 
weather of this kind would, of course, greatly affect 
the production of raw material, including food products, 
and the oscillation between general abundance and 
scarcity might, under simpler conditions, very well be 
associated with inflations and depressions of trade with 
a crisis at a period of transition. 

§ 18. Theory of credit cycles. — The periodicity of 
commercial crises at intervals of ten years, or at any 
rate the regular alternation of inflations and depressions 
during decennial periods, has been so marked that it is 
natural to look for some very general cause. The late 
Mr Mills of Manchester, who was an intimate friend of 
Jevons, and well known both as a banker and as an 
economist, sought for such a general cause, not in exter- 
nal nature in general, but in human nature in particular. 
Mr Mills was the author of the phrase " credit cycle," 
and his theory can be best expressed in the biological 
language that is at present so fashionable. Mr Mills 
made a minute examination of the life history of a 
credit cycle, and as he conducted his inquiry just 
after the great crisis of 1866, which had followed that 
of 1857 after the allotted time, he had very fine 
specimens for illustration. His description of a credit 
cycle would certainly apply to that period : " During 
each of these decades," he says, " commercial credit runs 
through the mutations of a life, having its infancy, 


growth to maturity, diseased overgrowth and death by 

Mr Mills argued that the remedy against the 
recurrence of crises was the spread of information, 
and just as some diseases are destroyed by light, so 
also — this was his main contention — crises may be 
destroyed by the light of knowledge and of publicity. 
That most solid of all recent works on economics, the 
Dictionary of Political Economy^ edited by Mr 
Palgrave, seriously asserts that the anticipation of 
Mr Mills has been verified in some measure by the 
course of events. 

This theory seems quite reasonable and even 
plausible in itself. Credit depends to a great extent 
on confidence, and an inflation of credit involves mis- 
placed confidence. It takes time to recover from the 
effects of a panic, or even from a narrow escape. 
After a crisis business is conducted on cautious and 
sound methods — for a time. Then the saying is 
verified that John Bull can stand most things, but he 
cannot stand two per cent. Two per cent, for the 
bank-rate may be quite satisfactory, but two per cent, 
for what we have called 'profit-intQrQ^ty and nothing in 
the shape of the wages of speculation, this is the two 
per cent, against which producers and traders rebel. 
They prefer their toil enlivened with a little risk, and 
their gains diversified with a little luck. Thus the 
period of depression passes into confidence ; the panic 
of the past looks less and less black, and the promise 
of the future more and more rosy ; and a new period 
of inflation is inaugurated. 

^19. Im'portance of reference to history. — We are too 


much inclined to think that this ancient history has 
no lesson for us, and that our methods of business are 
so sound and so different that all danger of commercial 
crises is past. We seem to think that steam and 
electricity have not only revolutionised production and 
transport, but have also revolutionised human nature. 
In sober truth, human nature remains much the same, 
and unless our superior knowledge is used to regulate 
methods of business, these changes in mechanical 
appliances will only give greater opportunity for 
mischief. Those who think commercial and financial 
crises are things of the past have only to recall the 
Baring crisis of 1890. It is quite true, in this case, 
that panic was avoided, and that the crisis never 
became general, and even the offending firm was 
rehabiUtated. But the catastrophe was so near, and 
for a time the danger looked so serious, that the 
example loses little of its force by way of warning. 
It was the practical wisdom, the moral courage, and 
the keen sense of public duty on the part of a few 
men that saved the situation. I will conclude this 
paper by recalling the words used by Viscount Goschen 
in a speech at Leeds a few weeks after the danger had 
been surmounted. After telhug the audience that we 
had only escaped disaster by the skin of our teeth, 
he goes on to describe the serious nature of the crisis. 
These are the words : *' No fertile imagination could 
exaggerate the gravity of the crisis ; and if I attempt 
to bring home to those who are listening to me now 
the serious nature of the crisis, I do so in order to 
accentuate the necessity of their turning their atten- 
tion to what I may call the necessity for soundness in 


our banking, and soundness in our currency, trans- 
actions. I doubt whether the public has thoroughly 
realised the extent of the danger to which what is 
called the banking crisis exposed us all. It was not a 
question of a narrow circle of financiers or traders. 
The liabilities were so gigantic, the position of the 
house was so unique, that interests were at stake far 
beyond individual fortunes — far beyond the fortunes of 
any class. We were on the brink of a crisis through 
which it might have been difficult for the soundest to 
pass unscathed, for the wealthiest to have escaped. 
It was a time when none who had liabilities or 
engagements to pay could say how they could pay 
them if a condition of things were to continue under 
which securities could not be realised, under which 
produce could not be sold, under which bills could 
not be discounted, under which appeared an absence of 
cash sufficient to discharge the liabilities of the general 

There is but one interpretation of these words, and 
that is — that in the opinion of this eminent authority 
we were within an ace of a crisis which would have 
exceeded in intensity the famous crisis of 1866. At 
the same time I have no wish to exaggerate the 
possibility of crises or the dangers that may arise 
when they do occur. Viscount Goschen spoke when the 
danger was hardly past ; but to us it is already part of 
ancient history. We can at present afford to be cool 
spectators and impartial observers. There could, 
however, be no greater mistake than to suppose that 
commercial and financial crises are as antiquated as 
old machinery; they not only may occur, but it is 


quite possible that for the time being the effects may 
be still more disastrous than in former times. All we 
are entitled to say is, that, as in the past, these effects 
will be obliterated, and commerce will revert to normal 







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A?R 24 1933 

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